Freelancing and being self-employed are the new frontier in the American economy. According to the Bureau of Labor Statistics, the number of self-employed workers in the U.S. increased from 14.5 to 15.5 million from 2014 to 2015, and is expected to increase substantially over the next few years. As Fast Co. recently reported, corporate downsizing and technology that makes it easy to work from home are fueling this trend.
When you add in professionals that have traditionally been compensated with no record of the financial transaction - such as performers, dancers, DJ's, musicians, etc. - and people who bring home a substantial amount of revenue in tips - such as bartenders, waiters, hair stylists, colorists, etc. - then you have a lot of professionals making a lot of money off the books.
This is a brave new world that requires brave new financial planning. After all, when you make a lot of money off the books you don't have an employer and a salary doing your basic financial planning for you, such as budgeting a regular income over a month or a year; paying into savings; taking money out for health insurance; reporting to the IRS; providing compensation for vacation and personal time, the list goes on. In other words you have to do the planning yourself.
Herewith the financial planning 411's when you make your money off the books:
Build a system for leveling out peaks and valleys in revenue:
Salaries naturally level out revenue. And if there is one thing that unites freelancers, people who live on tips, and the self-employed it's uncertain income. For freelancers and the self-employed revenue comes in waves - you may be incredibly busy for 2 months and hardly work for the next 2 months. And people who make a lot of money in tips can see wild fluctuations based on shifts at the restaurant or bar, number of clients in their chair, or even if they had a cold and missed a couple of day's work.
The plan is to build a system designed for leveling out these peaks and valleys. The first step toward managing this is to clearly separate your cost of living money from your spending money.
The way to do this is to have a primary account in which you deposit all of your money and from which you have all of your bills - rent, mortgage, utilities, etc. -- automatically deducted. (This is especially important for people who bring home money in cash from tips. Keeping tons of cash in your wallet encourages splurging. Depositing the cash helps prevents this because people on the whole are much more likely to splurge using cash already on them than to go to the ATM and pull the money out. Depositing your cash in a financial institution gives it a longer shelf life.)
Then every 2 to 4 weeks you transfer money into a separate account for everything else - ie. eating out, shopping, going out, etc. etc. So your living expenses are already budgeted, and your lifestyle expenses are determined and withdrawn based on your current financial landscape.
The difference between the two goes into building a financial bridge to get you through the valleys in revenue. You do this by taking this difference and stashing it in your primary account to cover your basic bills anywhere from 6 weeks to 9 months...whatever you can achieve. That way if you have a dip in income you don't have to go into debt to make it through until the money starts flowing again.
Take out money for taxes with every deposit:
Nothing gives the self-employed a sense of artificial wealth like depositing money without taxes taken out. And nothing hurts more than facing your quarterly tax bill - or, worse, an end-of-the-year tax bill with penalties - without having put money away for it.
The way to bypass both is to address your taxes with every deposit. One option is to consider allocating anywhere from 15% to 30% of every deposit into a third account specifically for your quarterly IRS and state taxes. If you feel you lack the financial discipline to do so, you can take a more tough-love approach by going on to the IRS website and your state's website and paying your taxes as you go with every deposit.
Know what safety-net and long-term planning benefits to prioritize first:
With most salaried jobs there is a system for benefits which cover everything from health insurance and sick leave to 401Ks and retirement. Freelancers and the self-employed have no such system. Although today many people in the service industry such as bartenders and waiters do have benefits that go along with the job, many do not. And even a bartender who does have, say, sick pay will only be paid their hourly wage while on leave, which may only be a micro fraction of their take-home income with tips.
In terms of priority, the first benefit that you should address is health insurance. Not only are you fined by the IRS for not having it, any kind of health issue could wipe you out and put you in serious debt. So the first order of business when it comes to benefits is to get health insurance.
The next order of business after health insurance is to create your own short-term disability and paid-leave infrastructure by building a cash reserve to use as paid personal leave, vacation, sick leave, etc. The rule of thumb is to have 2 to 3 months of basic living expenses stashed away in a no fee financial institution where there is no minimum requirement and no penalty for withdrawal. There's no set rule about how much you put in every month - even if it's a dollar then it's one dollar more than you had - the point is to create the habit of depositing money into the cash reserve and to build the reserve up over time. Like having money put away in advance to level out peaks and valleys in revenue, this will help prevent you from going into debt should you be unable to work for any period of time. It will also give you the resources to handle an emergency - such as needing to buy a new car - and to be able to follow through on a financial opportunity such as a potentially good investment that comes your way.
After that emergency safety net infrastructure is built then it's time to look into longer term savings and investments, such as a qualified retirement account like a Traditional or SEP IRA. To learn more about these and other retirement plan options, click here.
From there you can also begin to set up a goal-specific savings account for things like buying a home or educating children. How you go about it will depend on the dollar amount needed and the time frame. One of the ways to find an effective means of goal-specific savings would be to consult a financial advisor.
If you have dependents then life insurance - including Whole, Universal, Variable, and Term -- should be on the to-do list. To explore life insurance options speak to a financial advisor who is licensed to sell insurance or an insurance agent.
No matter how great the temptation, report all of your income to the IRS:
Nobody can deny the temptation of being paid with no record of the money changing hands and not reporting. After all, who wants to give away a substantial part of their check or the hard cash in their wallet?
But there are way more reasons today to report than to not. To begin with, the IRS now assumes an average tip rate of 8% of gross sales, and if you don't report will levy substantial fines.
Next, freelancers and the self-employed might not receive a W-2 from an employer or client and assume that the payments were not reported to the IRS, only to find out, after the fact, that they were. This reminds me of a story I recently heard of a successful DJ in New York who was certain that the nightclub that paid him handsomely in cash every Saturday was not reporting it to the IRS. The DJ wasn't reporting the income, but the nightclub was. This individual wound up being audited and paying huge sums in back taxes and penalties.
In addition, in today's economic environment showing a high income on your tax return is a must for basics like signing a lease, getting a mortgage, securing credit or buying a car. So by not reporting you may think you saved money in taxes, only to find out that you can't get a lease for an apartment or buy a car because your tax return income isn't high enough. Not reporting will also limit the contributions you can make to any retirement accounts because they are based on earned income. And reporting, say, 10 thousand dollars in income and having 40 thousand in credit card debt can trigger IRS tracking programs...something you really don't want to happen.
The brave new financial planning required when your money is off the books is, ultimately, simply about developing brave new habits.
To learn more about Michael, as well as access resources including videos and newsletters to help with basic financial planning, go to Michael's website here. You can also download Michael's app through Google Play or via the App Store which you can use to contact him with questions; connect with Michael on LinkedIn; and email him directly at Michael.Most@LPL.com.