5 ways to manage a 'flexible' income

If your salary fluctuates year to year, financial planning can be tricky. These steps can help.

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By Amanda Gengler, Money Magazine writer

David and Davene Gordon, with kids Divine and Davis, are doing just fine, thanks, on a 100%-commission income.
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(Money Magazine) -- David Gordon is on pace to earn 15% more this year than he did last year, which was itself 12% higher than 2006. Gordon, who sells ads for a Cleveland radio station, didn't land these impressive pay jumps by negotiating with his boss but with his clients. He works on 100% commission - so the more ads he sells, the bigger his paycheck. This year he thinks he'll bring home a record $165,000.

Things have been going well for him lately, to be sure. But there's an inherent uncertainty in his compensation structure. Gordon has no guarantee from year to year, let alone month to month. As he admits, albeit reluctantly, "There's always the possibility my income could fall."

It's happened before: Between 2005 and 2006, his income dipped 18%. And it could happen again. Industries change, after all. Just ask the best-producing realtors or mortgage brokers of 2005.

"David cannot maintain the utopian view that things will forever be as good as they are now," says Baltimore financial planner Tim Maurer. Gordon, 42, is particularly vulnerable since he is his family's sole earner - wife Davene, 38, daughter Divine, 10, and son Davis, 7, are counting on his paycheck.

If your family gets any part of its income from freelance work, consulting, or a small business, you're well acquainted with the Gordon's planning challenges. Even if you earn a salary, you're increasingly likely to find a share of your income doled out in performance-related awards, which you must re-earn each year, rather than raises. More than 90% of companies now offer some variable pay structure, up from 51% in 1991, according to HR consultancy Hewitt Associates.

Earning a living without prenegotiated pay doesn't have to be a struggle, however. You just need a way to make good use of the good times, to cushion yourself against the bad and to prepare yourself for the future. These measures will help you - and the Gordons - manage the uncertainty.

Set a "salary and live on it"

If you earn $100,000 one year and $150,000 the next, it's hard to gauge how much you can afford to spend. One way to smooth your cash flow is to come up with a monthly budget you can stay under, no matter what you earn.

To figure out your number, pull out tax returns for the past five years, find your lowest income and divide by 12. "You should be able to live off what you'd bring home in the worst-case scenario," says Maurer. Doing so reduces the risk that you'll have to tap savings or borrow in down years.

Then take half an hour to tally your essential monthly expenses - such as food, mortgage, car payments, as well as retirement and education savings. If you don't have taxes withheld, estimate your yearly IRS bill using last year as a model, divide by 12 and add that in as well.

If your monthly total exceeds the worst-case budget, it'd be wise to rein in spending. The easiest way to do this is to eliminate big fixed expenses - like that leased Mercedes or the annual ski trip to Banff.

To help you live under budget, set up your banking so all your pay is deposited to a savings account and have the amount of your expenses automatically transferred to a checking account on a certain day (or half, every two weeks). Then, only spend from that account. Do keep a cushion - say $2,000 - in the checking account as protection.

Plump up your cushion

Households with steady paychecks need three to six months of living expenses in the bank as an emergency fund. If your income is less predictable, however, strive to have at least a year's worth, says Jennifer Hartman, a financial planner in Los Angeles.

Besides the typical reasons to tap this fund - to pay for the emergency root canal or unexpected home repairs - you also may need to dip into it in lean years when you don't earn your baseline budget.

Better to use a cash stash than to borrow. (That said, it's wise to have a line of credit, like a low-interest-rate HELOC, just in case.) Put the fund in a high-yielding bank account or money-market fund. A good option: EverBank's money-market account, yielding 3.51% (888-882-3837).

Save right for retirement

For retirement planning, you can't simply use the standard estimate that you'll need 70% to 80% of your current income each year in retirement; you may end up with too little or too much saved.

Instead, look at how much you're spending today - go back to the tally you made earlier. Adjust it a bit based on how your expenses might change in retirement (no mortgage, more travel). This is how much your nest egg will need to provide for you each year.

To find out if you are on track to save enough, use our retirement planner, filling in that dollar figure as how much you'll want each year in retirement. You may need to adjust how much of your salary you save.

Once you determine an appropriate portion, include this in your worst-case budget so that you save even when business isn't booming. And immediately stash that percentage of each check in a retirement account.

If you're unsure how much you'll be able to put in a Roth or SEP-IRA, which have caps based on income, set the money aside in a savings account and come back to it at year's end.

Use gravy for other goals

In good years, you'll earn well above your budget. If you follow the previous advice, that money will automatically go to a savings account. At the end of every month, you can take 10% out for fun; then dole out the rest toward medium and long-term financial goals, says New York City financial planner Stacy Francis. Your first priorities: replenishing (or building) your emergency fund and paying down high-interest debt.

Fill gaps in your safety net

Usually the calculations for how much life and disability insurance you need are based on how much you earn; once again, you'll want to look at how much you spend.

For life insurance, consider what portion of your yearly expenses won't be covered without your salary. Multiply that by the number of years you want coverage (until your kids finish college or you hit retirement is typical). Add in any big stuff like kids' college costs. Get quotes for term policies via insweb.com or insure.com.

With disability insurance, even if you get it through an employer, it may not cover commissions and bonuses. See if you can buy additional coverage through your job. If not, or if you don't have a plan through work, start shopping with a trade group or insurance agent. Aim to cover fixed expenses, but be aware that policies usually replace only up to 60% or 70% of your earnings per year.

As for the Gordons, they've been managing their irregular income pretty well in good years. They wisely used the extra cash earned in 2007 to wipe out $15,000 in debt they'd accrued when David wasn't earning as much. But they need to plan better for down years so they don't rack up that debt again.

Their current emergency fund would cover them a mere three months; so they ought to build up to a year's expenses, advises Hartman. That's a lofty challenge, for sure, but if 2008 turns out to be the record year the Gordons are expecting, they'll be in a good place to start tackling such an important financial project.

3 fast fixes

David Gordon's pay is on pace to be up 15% this year, so he should use the extra money to get at these goals, says New York City financial planner Stacy Francis:

Bulk up liquid assets. Since Gordon is the family's sole earner and works on 100% commission, he needs an emergency fund stocked with at least a year's worth of living expenses, much more than his current three months. That would cover unexpected expenses, temporary unemployment and a long stretch of lower earnings.

Fund retirement. Gordon's employer does not match 401(k) contributions. Therefore, he should first put as much as he can in Roth IRAs for both himself and Davene. He will have more investment options and can withdraw his contributions, if needed, without a penalty. After that, he can max out the 401(k).

Pay down loans. The family used larger-than-expected commissions in 2007 to nearly wipe out their credit-card debt. Now they should work on their $38,000 in car loans before they attack the $50,000 home-equity line of credit. The car loans have a higher interest rate right now, and the interest is not tax deductible. To top of page

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