Manage your income’s peaks and valleys

No matter how unpredictable your earnings, you can gain the upper hand on your finances.

by Marty Kramer   Earning a living on commissions has pros and cons. With hard work and the right conditions, you can earn more money than you would taking home a regular paycheck. That allure, though, comes with the possibility of facing a few months–perhaps longer–when your income doesn’t quite measure up to your expectations. How, then, when you can’t be certain what your future income will be, do you make sure you can meet your financial obligations, invest for the future, and enjoy a few frills along the way?

Prioritize your income

"Pay yourself first," says Bryan Lee, a fee-only Certified Financial Planner and president of Strategic Financial Planning Inc. in Plano. He recommends that every month you pay all your bills and put a set amount into your investments before you spend money on anything else.

Lee, who also is president of the Dallas/Fort Worth Chapter of the Financial Planning Association, believes strongly in dollar cost averaging for investments. This strategy of investing the same dollar amount each month (or other defined period) regardless of the price of the stock or fund helps you avoid bad timing–making a lump-sum buy when a stock price is at its peak, for example. It works because when prices are lower, you are buying more shares of an investment, and when prices spike, you buy fewer.

Lee says that some people are inclined to do the opposite: buy more stocks when the market is booming and sell when it drops. That’s the reverse of how you should respond. (Think of the adage, "Buy low, sell high.") "Dollar cost averaging takes your emotions out of the equation," he says.

Get a handle on your outflow

Figuring out how much you can afford for certain expenses can be a trick in itself. Agents with no track record or wide swings in income can create a workable budget by breaking it down into levels, suggests Tracy B. Stewart, a CPA and Certified Financial Planner in College Station/Bryan. "The first level comprises basic, bare-bones items such as mortgage payments and groceries, but not Starbucks," she says. The second level is want-to-have items like the Starbucks, dining out, and movies. The third level includes vacations and summer camp–significant expenses that you would like to fund if you can.

Stewart cautions that you must also budget money for non-monthly items like life insurance premiums and vet bills. She recommends taking the total annual amount for each non-monthly expense and putting aside one-twelfth each month. That way, when the bill is due, you have the money on hand. "You will smooth out your cash flow and avoid unpleasant budgetary surprises," she says.

Lee, who uses the phrase spending plan rather than budget, recommends software programs like Microsoft Money or Quicken to help people get a clear and complete picture of their expenses. "If I ask somebody to come up with how much they think they spend monthly, they almost always underestimate their expense 20%-25%," he says. "They often forget haircuts, oil changes, gifts, entertainment–all those everyday living expenses that just go on the credit card." The software helps people account for all expenses. It also gives that person more precise information to provide to their accountant and financial planner.

Debbie Webb, a CPA with Thompson, Derrig & Craig in Bryan/College Station, reminds agents to include estimated income taxes when budgeting. Most real estate agents who work on commission need to make estimated income tax payments in April, June, September, and January. "The goal in making these payments," says Webb, "is to avoid incurring an underpayment penalty and to avoid having to pay a large and unbudgeted amount with the income tax return."

Something to fall back on

An emergency fund is an important consideration for anyone; perhaps more so for someone who does not receive a steady paycheck. "One rule of thumb is six months of living expenses," Lee says. "But many agents should lean toward even more–maybe nine or 12 months, especially if that person is single or responsible for the majority of the family’s income."

Stewart says a true emergency fund should only be invested in a checking, savings, or money-market account. The purpose of the account is to always have a certain amount of money available at any time, and investment vehicles that fluctuate in value or charge you penalties for early withdrawals do not meet this test.

Lee points out that while you wouldn’t want to dip into a CD, bond fund, or other investment for emergencies, having such resources might influence how much you keep in your emergency reserve. He offers an example of two people with similar finances except that one has $500,000 invested in taxable mutual funds. That person might be comfortable with only six months in an emergency account, while the other person might be better off with 12 months of emergency funds.

Build your future

Saving for something as distant and unknown as retirement can present another challenge. One strategy to address this uncertainty is to create a financial plan and revisit it annually. "A financial plan will project your net worth and cash-flow needs into and throughout your retirement years," Stewart says. "It will include various assumptions for the future, such as earnings, investment returns, and inflation. If circumstances change, you should amend the plan to reflect your current situation. Then you will get an updated projection and can make changes to your spending and/or investing as appropriate to meet your retirement goals."

Saving for retirement can even improve your current finances if you take advantage of retirement vehicles that give you a tax break. The most common and easiest to administer are the traditional IRA, Roth IRA, SEP and SIMPLE. "These tax-favored vehicles give you a big bang for your buck," says Webb. The amount you save and when you save it depends on your tax bracket and which vehicle you use, but it can easily reach the 27% range, saving you $540 of tax for a $2,000 contribution. Webb instructs that you may not want or be able to contribute to IRAs in years of higher earnings because Roth IRAs are subject to phase-out ranges as is the tax-deductible nature of traditional IRAs. The IRA phase-out ranges differ, so check with your tax professional to be sure you are eligible to make those tax-deductible contributions. However, SEPs and SIMPLEs are available to all self-employed persons without phase-out, so these retirement savings accounts are available to you in both high- and low-earning years. (If you have employees, you may be required to make contributions for them with SEPs and SIMPLEs.)

Watch out for the traps

A common mistake people with irregular income make is to spend more money when more is coming in. Stewart and Lee both see this blunder often. "Binge spending is a very easy behavior to fall into, especially when you know that a big deal is coming down the pike," says Lee. "It then creates a cycle, and people are often unable to catch up, especially if they hit a dry spell after that."

Stewart advises those with irregular income streams to smooth out their spending to correspond with their average earnings. "They need to live moderately even in flush times and sock money away for periodic future spending needs when the income stream might be lower," she says.

Webb adds that many people forget to set aside enough money for their higher income-tax bill. "This makes for an unpleasant surprise come April 15," she says. Not only might this set you up to owe an estimated tax penalty because you did not pay enough to the IRS during the year, but if you don’t have the cash to pay your tax bill when the return is due, the IRS will charge you interest and penalties that rival the high rates credit cards charge.

Lee offers one additional caution regarding financial planning. "Be careful with rules of thumb," he says. "Every situation is so different."

Photo © PictureQuest.

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