For many self-employed workers, taxes and savings are the two hardest expenses to keep up with. I think it’s because there’s no immediate benefit or consequence to either of them. A lot of people mentally plan their budgets based on a certain dollar amount that often hasn’t been adjusted for taxes or savings. So you might end up spending all your money and not having anything left for either of these two.
Living Expenses/Taxes/Savings Ratio
This “live on the rest” budgeting system isn’t something I made up. I’ve read about it over and over in personal finance books, so I can’t take credit or give it to anyone else for that matter.
The gist is that you live on 70% (or some other percentage) of your income. The other 30% goes toward taxes and savings. When you get paid – or when you pay yourself – immediately set aside 20% for taxes and 10% for savings. And then, you live on the remaining 70%. If your monthly income is $4,000, you would set aside $800 for taxes, $400 for savings and you live on the remaining $2,800 left for your living expenses. It makes a big difference in how you budget, physically and mentally.
I mention the mental budget because we often make plans for our money long before we ever receive the money and even before we commit to a paper budget. If you’ve planned your spending based on one amount and what you’re actually able to spend is a much lower amount, adjusting is going to be painful. But, when you have more realistic expectations of your income, the budgeting process is much easier.
Tweak the System
For me, the system works best when I pay myself a set amount each month. That way, I can work with a lump-sum amount. But, you may have to work up to that point if you pay current month’s expenses with the current month’s income. You also budget this way on a payment-by-payment basis. Just split up your payment, 20% in an account with taxes 10% to savings and 70% in your primary checking account. If you’re faithful about splitting up your payments, you won’t have to play catch-up later on.
These numbers are generic and can certainly be adjusted, especially if you’re in a higher tax bracket. You can use an average tax rate calculator to calculate your Federal tax rate, then add 15.3% to compensate for self-employment taxes, and don’t forget to consider your state taxes. If you’re trying to pay off debt, you might use a 65/20/10/5 ratio where 5% of your income goes toward debt payments.
At first, the system may be painful. The mere thought of only getting 70% of your income is undoubtedly depressing. But, it’s pretty close to how things work when your employer deducted taxes and benefits from your pay. Believe me, you’ll be happy you did it this way. When it’s time to pay your estimated taxes, the money is already there. And though retirement may be while away, it’s a big goal to prepare for. The sooner you start and the more disciplined you with saving, the better off you’ll be when it’s quitting time.