Most of us are familiar with the financial rule to have at least 6 months of expenses in savings. But most of us aren’t following that rule: the average American family has only $3,800 in savings. So if you’ve neglected your savings, you’re not alone.
But don’t follow the crowd on this one, especially if you're self-employed! The self-employed - whether you're an entrepreneur or a solo freelancer - especially need to be disciplined about savings, because they face more risks than someone in a typical 9-to-5 job. By risks, we mean anything that puts you in the hot seat financially: the flu, a client who takes forever to pay or a broken laptop. That money under your mattress (or preferably, in an interest-bearing liquid account) is your self-funded insurance against risks. Here’s how to build up that self-insurance fund, which is an important piece of financial planning for entrepreneurs.
Saving on a variable income
If you're self-employed, you probably have a variable (and maybe unpredictable) income, so saving can be tricky. But it’s doable with some reengineering of basic financial management principles and discipline.
First, you should aim to save around 10-20% of your income. This money will go toward (in order): 1) your short-term emergency fund (i.e., self-insurance), 2) your retirement and 3) short-term goals (like a vacation). It’s important to build up emergency savings before putting money into a retirement account (because it’s unlikely that money would be around for retirement anyway if emergency strikes) ** **
You’ll be making savings contributions on a monthly basis – which is where it gets tricky for people with variable incomes. In this case, you have two options: 1) save based on your lowest income month or 2) save based on your monthly expenses. Option 1 is best for people who have a few years of income history from which to make reliable predictions of low and high cash flow months. Option 2 is for everyone else.
Option 1: saving based on your lowest income month
Review your records over the past few years. Flukes aside (e.g., a month in which you were sick and didn’t work much), what was your lowest income month? Is it reasonable to assume that would be your lowest income month in the year ahead? If so, set up an automatic savings plan based on that income. So if your lowest income month is $3,000, and you want to save 10% of your income, set up an automatic savings sweep of $300 per month. In months where you earn more than $3,000, you’ll have to manually contribute 10% of that excess amount into savings.
Example: you earn $5,000 in one month. At the end of the month, $300 is automatically swept from your checking to your savings account. You also manually move $200 (10% x [$5000-$3000]) into savings. The rest ($4,500) is for you to allocate and spend according to your budget (which you should also have).
Option 2: saving based on your monthly expenses
Reviewing at least the past 12 months, figure out your average monthly expenses. Make sure to include all "hidden" expenses (these are irregular items like car repairs and birthday gifts). Also include a reasonable amount to treat yourself occasionally (but less extravagantly than this <link>). From your earnings, "pay yourself" a monthly income equivalent to that expense amount. Put an additional 10% automatically into savings. Example: your monthly expenses are $2,000. You pay yourself that amount from earnings, plus $200 directly into savings. Any earnings over $2,200 goes into separate savings (a "slush" fund). In slow months where your earnings aren’t enough to pay yourself, you can make up for the shortfall from your "slush" fund (because you’ve self-insured for lean times!)
Saving and budgeting is like dieting – it requires discipline. (Free tip: don’t start a new budget at the same time you start a new diet). But most of us choose the entrepreneurial path because of the freedom and creative challenges. Just think of financial discipline as the price of entrepreneurial admission.