Saving for Retirement on a Variable Income
This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.
How do you save for retirement when you have a variable income? One month, your income may not be enough to float your business expenses, much less the mortgage and personal living expenses. Other months, you might make enough to cover off six months of expenses. So not only is basic budgeting a different story when you have a variable income, but so is saving for retirement.
Below is a technique you can harness to take some of the guesswork out of saving for your own retirement, while still balancing out the need to cover other expenses. And for the lazy at heart (myself included), it reduces the discipline required to do the whole thing manually in lump sums.
This strategy is best implemented when you have a few years of variable income patterns under your belt for both stability and ease of projections.
Step One: Determine What Percentage of Your Income to Save
Take a peek at your annual income for the last few years. Hopefully you already know how much money you need to save each year to satisfy your retirement goals (by working with a financial planner). Simply translate that number into a percentage of your earnings.
EXAMPLE: Purely for the purposes of this illustration, I will assume that you have an average annual income of $100,000 and are prepared to save 10% ($10,000) per year for retirement. (These are by no means the recommended numbers, as your retirement plan depends on many factors, including your age, income, investments, and financial prospects. Please consult with a financial planner to incorporate this strategy into your personal financial plan.)
Step Two: Determine Your Lowest Income Month
In reviewing your records and income trends, find the low-income periods of the year. What was your lowest income month? Was your lowest income month a fluke, or a somewhat predictable function of the season or industry for example? In identifying your trends, now is the time to predict your lowest income month that you will experience in the next 12 months, based on experience and educated estimates.
Don’t worry too much about erring on the safe side of your low income predictions. If you have an unpredictably bad spell, you can adjust your variable income retirement savings plan on the fly. The idea is simply to get a working estimate to start with.
EXAMPLE: Although the average monthly income for a $100,000 career is over $8300, let’s say your lowest income month is $4,000.
Step Three: Set up an Automatic Savings Plan
Based on your answers from the first two steps (being your annual retirement savings percentage and your lowest income months), it is time to set up an automatic savings plan. Simply apply the percentage you wish to save towards retirement to your lowest income month. This ensures that you are always saving something towards retirement, but that when money is tight, the amount you are saving is proportionate to your variable income (and not the retirement savings end-game).
This strategy is also a nice way to take advantage of dollar cost averaging within your retirement investments.
EXAMPLE: In step one, you decided to save 10% of your annual income. In step two, you determined that your lowest income month is likely to be $4,000. Thus your automatic retirement savings plan should be 10% of $4,000 — which is $400 per month. This should be affordable, even given the lower income. Read on for variable income management tips to help you navigate fixed expenses and variable income.
Step Four: Make Manual Contributions Each Month (or Periodically)
Unfortunately, $400/month in regular retirement savings is not enough to satisfy your goals of saving 10% of your income for retirement. This is what we will call your “base-line” contribution. So, each month that your income exceeds the base-line threshold, you must also tuck away 10% of your income over and above your base-line.
EXAMPLE: One month you earn $6,000. This is $2,000 more than your $4,000 lowest-income baseline, so you need to save 10% of the extra $2,000 (which is $200).
Another month you have a great run and earn $12,000. Subtract your $4,000 base line, and you are left with $8,000. 10% of $8,000 is $800, which is the amount you need to save for retirement that month.
Note: Making manual contributions could be a hassle, especially if you want to simplify your finances and the process of saving money. As you will likely have already discerned in living with a variable income, you must pad your low-income months with savings from the higher-income months to meet all your financial obligations (or have other means of covering your expenses, such as with a high-quality charge card). So hopefully you already have a system in place to achieve this. If not, it can be as simple as setting up a high-interest online savings account and transferring your monthly manual retirement contribution electronically, then periodically contributing the accumulated balance to your retirement account. Just be sure not to “borrow” from this account!
Step Five: Review the Plan Annually
As your business grows, so too will your income (ideally). As you review your plan and your monthly income trends, you may discover that your base-line amount is too low. If that is the case, then simply increase your automatic contributions to reflect the new low-income base-line, and you will continue to save a proportionate amount of money for your retirement, and will reduce the amount you have to contribute manually.
EXAMPLE: It has been a while since your income was as low as $4,000. Instead, you are now finding that your lowest months are at least $5,000. Increase your automatic contributions to $500 per month (10% of $5,000).
Alternately if times are tough and your income has dropped, you can lower your automatic contributions accordingly.
Advantages of This Plan
Given that navigating automatic payments can be stressful given a variable income, this strategy allows you to safely take advantage of dollar cost averaging for your retirement investments.
By automating at least part of the plan, your chances of meeting your retirement goals is increased. Business owners are notorious for not saving for retirement; either because they believe the business is their retirement (without actually having a succession plan to show for it), or because they are unable to wrap their heads around having to shell out money for yet another expense. Leaving 100% of your retirement contributions to manual discipline is rarely successful, especially if you are not incredibly fastidious about setting money aside.
As your income increases, you are still saving a proportionate amount of money for retirement. Assuming you can deduct your contributions for tax purposes, then saving a percentage will better help you calculate your taxes payable and will keep your taxable income a little more steady.
Lower income months won’t leave you strapped for cash with an ambitious retirement contribution plan based on your average income (which doesn’t take into account the highs and lows of a variable income lifestyle).
Additional Variable Income Management Tips
On those higher-income months when you invest the extra cash manually for your retirement, you would be well-served to tuck away additional funds in a similar manner (but in a different account) to cover off other fixed monthly expenses and have on hand when your income in other months is not quite sufficient. This is not your emergency fund; this is your slush fund to compensate for your variable income in a world where fixed expenses and payment deadlines rule the roost.
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