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The majority of working people earn a regular paycheck with equal portions of their annual after-tax salary deposited into their bank account. Taxes are automatically deducted and sent to the IRS, the appropriate state tax authority, and other entities with claims on that income. This is not just convenient. It is also predictable, and predictability is extremely helpful when planning how to spend, save, and invest.
But not everyone receives a regular, steady paycheck—in fact, many high earners do not. Consultants begin and end engagements in no particular pattern, an attorney’s fees often depend on the size of a settlement or judgment, high-performing salespeople can earn sizable commissions paid in lump sums that are typically not paid until after a sale closes, and many key employees earn year-end bonuses that comprise a substantial portion of their compensation. And if you have a sizable portfolio of taxable investments, your investment income can be highly variable.
This lack of predictability in one’s income can make financial planning seem complicated—but it doesn’t have to be. In this article, we offer insights and guidance for high earners with a variable income about how to handle spending and investing with an uneven income stream.
Common Challenges with Irregular Incomes
If your income is irregular throughout the year, you may fall into habits that can deliver unpleasant “surprises.” For example, if you have a particularly lucrative month and your bank account balance swells, you might overspend to reward yourself. That is essentially living as if there is no tomorrow, which may sound spontaneous and carefree until you realize you lost ground with respect to meeting your financial goals because you overspent in that high-income month. You might also underpay quarterly tax obligations (more on that later), resulting in penalties. On the flip side, when your income in a given month is below 1/12th of what you expect to earn over the year, you might pull the purse strings too tightly, reducing your spending unnecessarily and piling up too much cash in your checking account, which you could invest to earn a higher return.
Neither of these is an optimal choice, but they are common, and certainly understandable. Here’s what we recommend instead: make the unpredictable predictable. That means making a plan to allocate the total amount you expect to earn over the year to spending, saving and investing, taxes, and perhaps charitable giving, even if the money comes into your bank account in irregular chunks.
Planning Creates Predictability
First, note that although your income might be quite uneven throughout the year, you can probably still estimate a range for what your total income for the year will be. Armed with that information, you can make two financial plans – one for how to spend and invest if your income turns out to be at the low end of that range, and another to guide you if your income ends up at the high end. A good advisor (with software tools you probably don’t have) can help you make these plans.
As you might expect, your after-tax income for the year – even at the low end – should be able to cover essential expenses such as housing, food, car expenses and so forth. If you would not be able to cover your mortgage payments or your children’s school tuition without the same bonus, commissions, or investment income you earned last year, you may need to rethink your “mandatory” expenses. Assuming you could pay mandatory expenses even in a “low income” year, you can move on to the next step of allocating the rest of your income to retirement savings (401(k) or IRAs), additional investments, and charitable giving if that is a priority for you.
Under a well-structured plan, “excess” income in a higher income month might be allocated to meet your annual goal for retirement savings, or to pay for a planned vacation. In other months when your income is lower, you might not allocate any of it to savings. That doesn’t mean you are living on the edge or failing to save for the future – if you make a sound spending and saving plan based on your expected income for the entire year, the income and spending/saving may vary each month, but over the course of the year your goals will be met.
Managing Estimated Taxes
People who receive “lumpy” income in the form of a bonus or commissions from an employer have taxes withheld from that payout. However, consultants and others who are paid by billing for their time or services rendered must pay a portion of their income as estimated taxes every quarter. And if you have substantial income from investments held outside of a 401(k), IRA, or other tax-advantaged account, you will have to make quarterly tax payments.
Under IRS rules, if you expect to owe tax of $1,000 or more from being self-employed, or from investment income, rental properties, gambling winnings, or any other source of income from which taxes are not withheld, you must pay quarterly estimated taxes covering the total tax bill you think you will owe for the year. Estimated taxes are supposed to be paid in equal quarterly installments (note that state tax rules can vary), and you can plan for this if your income for the year is fairly predictable in total, even if it arrives unevenly throughout the year.
For example, if you expect to earn $X in the first, second, and third quarters of the year, and $3X in the fourth quarter, you need to make equal estimated tax payments each quarter based on an annual income of $6X, as if you had earned $1.5X each quarter (even though you didn’t). So, you incorporate taxes owed on that $1.5X each quarter into your spending plan for the year.
Estimated taxes are calculated on your projected annual income. But imagine you had been making quarterly tax payments based on what you expected to earn for the year, then unexpectedly earned much more in the last quarter of the year. Not a bad problem to have, but clearly your estimate was off and you have been underpaying your taxes, even though you couldn’t have known what payments you should have made. The good news is the IRS has a “safe-harbor” rule that enables you to avoid paying underpayment penalties: you can pay 110% of your prior year’s tax bill in four quarterly payments, and no matter what your tax bill turns out to be for the year the IRS considers those payments a “good faith” effort to meet your tax obligation (if you earn less than $150,000, you can pay 100% of the prior year’s tax bill).
In general, if you have non-W-2 income, it’s a good idea to take advantage of that safe harbor and include quarterly tax payments in your spending plan to cover 110% of what you paid in taxes the previous year. If you are confident your income will decline this year, perhaps because you are cutting back to part-time work or you had a big gain from selling an investment property last year, you could go through a more painstaking process of estimating your tax bill for the year (consult with your tax advisor). Of course, you can still pay 110% of last year’s tax bill and get a refund, but you are making a loan to the IRS while awaiting that refund.
Remember, Roth conversions increase income and taxes owed. If you make a sizable Roth conversion in a single quarter (most often, the fourth quarter), you will owe taxes on the amount withdrawn from your traditional IRA. But you might not have anticipated doing this at the beginning of the year, when you calculated your quarterly estimated tax payments. The conversion may have pushed you into a higher tax bracket, which could magnify the tax impact of the extra taxable income generated by the Roth conversion. That means you underpaid your taxes for most of the year, and the IRS may assess a penalty. You will need to file IRS Form 2210, which is long and fairly intimidating. You’ll want to consult with a tax advisor on this, but if it makes sense in your situation to do a Roth conversion, don’t let the tax issue dissuade you.
Income versus Cash Flow
Of course, dividing your annual income after taxes by 12 does not reflect your monthly cash flow if your income is uneven. The mortgage has to be paid every month, regardless of when your bonus is paid or when you complete a big project and can bill the client. It is critical to remember that higher than average income in a given month is not a windfall. You didn’t just win the lottery or receive an unexpected inheritance. If you earn very little in some months, and have very high income in other months, it makes sense to hold back a big portion of what comes in during the “gusher” months to provide cash flow during the “dry” months. You can even open a separate bank account, transferring “excess” cash flow from Gusher Month 1 to the account used in Dry Month 2.
The ability to manage your cash flow needs and having the discipline to stick with a financial plan is helpful preparation for when you are retired and might decide to withdraw a lump sum from your retirement savings to cover your expenses for the coming year.
Planning Smooths Variable Income’s Rough Edges
High earners whose income is erratic from month to month, even year to year, need financial planning as much as those who earn a regular income stream. In fact, those with irregular income streams need some additional planning and therefore can benefit even more from working with an advisor who has experience in this area. Financial planning that specifically addresses the challenges of having a variable income will provide much-needed predictability – it may not be exciting but it will make your financial life better.
This article was originally published here and is republished on Wealthtender with permission.
