Managing and organizing income is one of the most stressful and important tasks for a full-time freelancer.
It's a great feeling to begin earning real money as a freelancer. It's liberating! Who the heck knew you didn't need a boss to earn income?
As freeing as it is, being a freelancer—especially a full-time freelancer—comes with responsibility. Aside from earning and performing the work, one of your most important responsibilities is how you manage your money, because if you don't do it wisely, you could end up owing thousands of dollars you don't have.
I've written previously about one way to design a freelance financial ecosystem, and that's what I'll use as the basis for discussion here.
The important piece is that you have a separate bank account to hold your freelance money. That account is responsible for saving for taxes and retirement, and you use that account to pay yourself a salary. In other words, you have configured regular, automatic transfers that move a consistent, pre-specified amount of money from your freelance account to your personal checking account, having already accounted for taxes.
What I'd like to focus on here is the makeup, design, and maintenance of your freelance bank account. I'll use the graphic above to show what's sitting in your bank account and what role it plays.
This one's easy, right? The actual money in your account is your account balance. That's all we need to know about it for now, but we'll use it in other calculations as we move along.
The minimum balance is the minimum amount of money you require be in your bank account. Some banks make this number easy to determine because they give you a balance under which you have to pay a monthly service charge.
I recommend you shoot for 13 weeks (3 months) of paychecks as your minimum balance. That means if you pay yourself $1,000 every two weeks, your minimum balance is $7,500. (Paycheck distributions are discussed in that other article I mentioned.)
This is the container you always fill first, and it just sits there. It's what I consider to be emergency funds. In cases where you can't find any work for a period of time or you need to fund some life emergency, you can pull from this fund. You should avoid pulling money from this portion of the account if you can, but if you're forced to do so, it must be the first to be refilled.
Withholding is the next tier. It's where you hold your taxes, investments, or any other pre-tax money you're going to spend.
Unlike minimum balance, you can never take money from this account, because, especially with taxes, you already owe that money to the government. And that's the whole point of this bank account design—being smart so you don't end up owing thousands at the end of the year.
And remember, taxes are higher as a self-employed business-person. So I suggest holding at least 40% of your gross income in this bucket. And if, after paying your taxes at the end of the year, there is money left in here, take it as a bonus.
(BTW, the reason I put this above minimum balance while saying you can't take from it is because it really is meant to be more liquid than your minimum balance. Ideally, your minimum balance just sits there, while you have to withdraw from withholding at least once a quarter to pay estimated income tax.)
Reserves are everything else that's left over, but there are two specific types of reserves:
Runway is the section of the account that gets staged to pay your salary. Like minimum balance, I suggest you hold 13 weeks (3 months) worth of paychecks in here. That way if you don't have money coming in regularly, your recurring transfers will still have money available without dipping into withholding or minimum balance.
Anything else left in the account is a surplus! It's a pseudo bonus, and assuming you've already withheld 40%, you're free to do what you want with it.
I'm super conservative with my approach to surplus. I note the amount of surplus at the end each of each quarter. So, say on April 1 I have $2,000 in surplus. I mark that down. Then, when the next quarter ends (July 1), if I still have $2,000 in surplus, I'm allowed to take up to that amount ($2,000) as a dividend. But if the surplus is less than $2,000, I'm not allowed to take any money out, because that's an indication that I've lost money this last quarter, and therefore should focus on being more profitable before I remove any extra money.
Oh, and one big important note, don't forget to withhold taxes (and move them to withholding) from your surplus earnings!