Navigating Cash Flow Planning with Variable Income
Cash flow planning is at the core of a sound financial plan. It's how you link all the pieces of your plan together and get them working effectively towards your short- and long-term goals. It incorporates income, spending, saving, and investing into a framework that builds wealth. A strong cash flow plan can also help you strategize debt, taxes, your career, and how to optimize non-financial assets, like an investment property.
But how can you activate effective cash flow planning when you have variable or unpredictable income? This could be the result of many types of income.
· A large annual bonus
· Commission-based income that is seasonal, like real estate or related services
· Commission-based income that is more variable
· Professional services income, such as accounting or legal services
· Owning your own business
Having "lumpy" income complicates your financial picture because it can be challenging to plan monthly expenses effectively. It can also impact your financial mindset by always keeping you fluctuating between scarcity and abundance. It’s easy to fall into the tendency of worrying through the periods when income is low and then overspending when you hit a period of higher income to reward yourself. Even the most disciplined spending plans can fall victim to this, and at best, it can cut into achieving your goals in the timeframe you've identified. At worst, it can derail your plan entirely.
There is a solution – we break down how to map variable income to the goals you've already identified so that you can create an effective cash flow plan.
Lengthen Your Financial Horizon
Because billing cycles are monthly, it's common to break down your saving and spending amounts into monthly "chunks." But it's better to think from an annual perspective when your income has low tides and high tides. Targeting a fixed annual number tied to other goals can help you keep perspective on your savings goals.
For example, setting a target of contributing the maximum to an IRA annually can also be part of your tax planning process. Rather than think about it as a monthly amount, start with the $6,000 maximum annual contribution. The same strategy works for a vacation fund – think of it as the total sum of all vacation spending, and plan to put that amount in a separate account.
Create an Accumulation Account
This Accumulation Account is different from all your other bank accounts – it's a holding tank for income that will get reallocated to specific saving, spending, or investing needs based on the appropriate schedule for the outflow. Depending on your particular goals, this could be quarterly, semi-annually or annually. It should be set up as a savings account and linked to other accounts.
As you earn more than your minimum monthly required income, this is what you need to maintain your monthly budget, you can easily set up accounts so that the extra money sweeps into a separate account. We like to call this separate account an Accumulation Account. Months that see higher income should automatically have more funneled into this Accumulation Account.
Establish a Funding Schedule
Annually, map out everything that needs to be funded for the year. These goals and amounts should be divided into short-term and long-term obligations and should be ranked in order of importance. For example, a family vacation would be a highly important short-term obligation because you need to start planning it early.
To visualize how this works, let's look at a quarterly funding schedule in a quarter where income has been higher than usual, so excess funds have been swept into the accumulation fund.
Step 1. Let's assume there is $15,000 in the accumulation account. If the family vacation is earmarked at $8,000, the first obligation can be fulfilled right away. Transferring the entire $8,000 into the vacation spending account means vacation booking can start in advance, allowing you the maximum flexibility to take the trip you want at the price that works.
Step 2. Moving down the list, the next item could have a longer time horizon, but still high importance. Saving for retirement would meet these criteria. Putting the entire $6,000 towards the Roth contribution ensures that the account is funded and can have growth potential and that tax planning is on track.
Step 3. The remaining $1,000 would then be added to another longer-term savings goal, for example, a 529 education savings plan.
Assuming there is again a balance in the accumulation fund in the next quarter, different goals would be prioritized. For example, topping off an emergency fund, continuing to contribute to a 529 savings plan, or paying down mortgage or student debt more quickly could be on the agenda.
The Bottom Line
Having a cash flow plan is the best way to ensure your financial plan will help you reach your financial goals. When you have a variable income stream, it's essential to plan for utilizing excess income effectively when you have it available so that things stay on track.
Because the money is swept out of your primary checking account and then put to work where it makes the most sense, it can help you avoid overspending. Knowing that your money is working for you can also help you cultivate a healthy money mindset, so you can maximize your opportunities.
Brandy Branstetter, CFP®