Managing Money as a Freelancer

When you approach money management as a freelancer, especially a new freelancer, be scientific, conservative, and strict.

When I left my comfy job to go out on my own, the situation was about as good as it could be -- I could join my wife's health insurance without a major increase in premiums, I had space for a home office, and I had a couple of hourly contracts ready to go.

Among all the scary side effects of leaving the comfort of an employer, the idea of not having a regular, guaranteed paycheck was the most unsettling. (Paying for coffee was a close second!)

So, I came up with a system to mitigate the risk of panic, were I to lose work on which I was depending.

Before we dive into the details, I want you to preface this with two minor details:

  1. I'm sharing only the basics of the system. There's more to it, and I'll go into more detail in the future.
  2. The design of this system is always in flux. I take time every few months to evaluate how it's working and adjust some of the underlying logic to account for new scenarios I encounter.

When we really get into the details, there are some complexities in the system. But the core of it is super simple -- you pay yourself in paychecks. That unsettling idea of not getting a consistent paycheck can be lessened by giving yourself a paycheck.

Here's how I do it:

Step 1: Open a Bank Account

First, open a bank account. This is where you're going to store all the income from your freelancing work.

If you have (or will have) an LLC setup for your business, great-open the account in its name. If not, it's no big deal, just open another account. (For personal accounts, I love Simple, but go with whatever bank you prefer.)

Your account should come with a debit/credit card, which will come in handy later.

If you are in a personal relationship where you share money with the other person, you're welcome to add account access to that person, but I suggest you don't share this account. The account is for business only.

In my case, I have two separate accounts for various business needs. My wife does have credentials to both, but only to view balances.

Step 2: Determine Your Living Expenses

Next, figure out your living expenses. This isn't what you want to make, but what you need to live.

If you currently have an employer, the easiest way to figure this out is to look at your net income, and how much of that you spend. (i.e. Don't count money you save.)

If you don't know and if you're already out on your own, then take a guess. Look back at last year's bank statements and see how much you've spent. If you work primarily with cash, there's a bit more guessing you'll have to do.

TIP: This is also a good time to take a microscopic look at your spending habits and begin to cut unnecessary expenses.

Step 3: Business Expenses

I'm jumping ahead a bit, but let's pause and talk about business expenses.

First, when you have a business expense, you should use your business account as the payment source. Do it for anything business-related-printer paper, pens, parking for a meeting, lunch with a client. It all counts. Use your new bank card and (SUPER IMPORTANT!) save a record of the expense amount, date, description, and an image of the receipt.

Second, estimate your annual expenses. This can be really, really difficult as a freelancer, especially early on. But we all have different scenarios and our expenses will differ greatly.

If you have to guess, try to be conservative. For example, I am a software developer, and I anticipated expenses for domain names, hosting services, etc. But I didn't account for going to so many meetings to either talk about current work or to earn new work. And these meeting were either in a coffee shop or without free parking. So if you don't know, guess, then double your guess.

Step 4: Taxes & Insurance

Taxes! Blargh!

Did you know that your employer paid part of income, social security, and medicare tax on your behalf? Now you have to do this.

Did you also know as a sole proprietor you are supposed to pay estimated taxes every quarter? (Don't worry, we'll talk more about that.)

With taxes, estimate the percentage of income that you'll have to pay in taxes. When I first started, I used tax withholding as a way to be extra conservative. I used 50%. That's way way way conservative, but it was a device that helped me. Nowadays I use 40%, which is still conservative, since the rate for me will end up being about 30–35%. Start with at least 40% if you can.

Next, you should consider how much you'll spend (in addition to business expenses), that are deductible. The two areas that come to mind are health insurance and retirement account contributions. You'll want to have an estimate of how much you'll spend in related areas for determining your base salary.

Step 5: Your Base Salary

We finally have everything we need to determine your base salary. This is how the math works:

  • Take your living expenses for a year,
  • Divide it by one minus your tax rate as a decimal (example below),
  • Add your business expenses, and
  • Add any pre-tax expenses, like insurance or retirement investments.

Let's do an example. Say I live off of $2,000 each month, that I expect $4,000 in business expenses annually, I don't contribute to a 401(k), but have to pay $250 per month in health premiums, and am using a 40% tax rate.

  • My expenses are $2,000 per month x 12 months, or $24,000.
  • To be able to afford taxes of 40%, I'd divide $24,000 / (1 - 0.4), or $24,000 / 0.6 = $40,000.
  • Add business expenses of $4,000, so $40,000 + $4,000 = $44,000.
  • And then my insurance cost of $250 per month, or $250 x 12 months, which is $3,000, so $44,000 + $3,000 = $47,000.

There it is. Isn't that silly, though? You to earn $47,000 salary just so you can spend $24,000 throughout the year?

Step 6: Paying Yourself

Any money you make as a freelancer should go directly into your freelance business account. (I recommend keeping records of all transactions, but we'll save those details for another article.)

Next, build out a paycheck strategy. My strategy is to pay myself every other Friday. And I have the bank account configured to transfer automatically to my wife's and my joint checking account.

A quick note on humans: My wife doesn't have to look at all the business transactions, or the balance in the business account. She sees my paycheck come into the shared account every two weeks and that's what allows us to run our lives together. Other partners may not be cool not knowing the details of your business account. That's totally fine. But please, do not withdraw money from your business account unless it's a paycheck, business expense, or investment in the business.

Also note that what you transfer to your personal account is not your salary, because the other thing our business account is doing for us is withholding taxes. This is so you don't take income into our spending accounts that you'll later have to pay back in taxes.

To wrap, if you were using the every-other-week strategy, there are 52 weeks, so that means 26 pay periods. With the $2,000 per month living expenses, it's $2,000 per month x 12 months, or $24,000 per year, which means $24,000 / 26 pay period =~ $925 per pay period. So, every two weeks you'd transfer $925 to your spending account.

Step 7: Paying Taxes

As I mentioned, you are required to pay estimated taxes every quarter. This applies to the federal government (IRS) and likely your state, too. You can read more about the IRS rules here.

One of the biggest benefits of this system is that your business account is automatically withholding taxes for you, so when it comes time to pay taxes, that money should already be available.

Note that paying estimated taxes will not be calculated on your base salary, but on what you actually expect to make in full, minus expenses. In your first few years, this will probably change a lot, and that's OK. If you overpay, you'll get your money back. If you underpay, you'll owe some at the end of the year. (Note that it's beneficial to overpay because underpaying too much can result in paying a penalty fee.)

If you follow this system, the money you must pay should always be available.

Step 8: Insufficient Funds

OK, this is all great and stuff, but what happens if you don't have enough money to fund a paycheck? Or what if you can't pay your estimated taxes?

Well, first off, you should be keeping track of the portion of your account that is meant for tax withholding. (Multiply your withholding percentage by your net income, and subtract any tax payments you've made.) Or, to say it better, you should track the money that is available to pay you in paychecks. If that runs low, it should be a red flag.

When you have to raise a red flag, that means you're not making enough to cover your living expenses, and that is a problem, but remember we've built some contingencies in here, primarily in overestimating the tax percentage.

So if you need to dip into the withholding, try to do it scientifically. Say, temporarily adjust the withholding percentage to 35% and see if that gives you enough.

I advise you to be conservative when you can be, but sometimes you may have to reach in your pockets to hold yourself over until you can send that next big invoice.

The Next Step: Luxuries!

There's a lot more I can share on this whole philosophy of managing money as an independent worker, and I plan on doing so.

But, until I can write more on the subject, I'll leave you with this:

When you approach money management as a freelancer, especially a new freelancer, be scientific, conservative, and strict. Follow this system, or a system like this to make sure you're not spending money you should have held for taxes. And omit luxuries until you've met your base salary for the year. Don't worry about saving, investing, or retiring until you have a solid base.

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