I have been self-employed for over seven years now. I have worked as a freelancer during this period, owned a small business, and invested and traded in stocks.
One crucial lesson I learned doing all that is — managing your money well assumes a very different kind of prominence when you are self-employed. It becomes critical to both your survival and success. But at the same time, it gets easily overlooked. In part because you were never taught how to do that. But also because you try to focus on other more obvious responsibilities.
It took me a couple of years and considerable pain to have this realization. And initially, I thought I was some great fool to have made such glaring and expensive financial errors. But talking to other freelancers about it, I realized such mistakes were common in the community. Most of them did get better eventually, but often at high costs.
Now it’s best to learn from others’ mistakes. So if you are a freelancer, be smart and avoid these four financial blunders.
1. Not Knowing How Much They Actually Earn
Many freelancers, especially those who are young and relatively inexperienced, don’t even know how much they effectively make in a month. All they have is an estimate based on whatever numbers they can remember from the recent past.
That is terrible because it ignores the periodic fluctuations, business expenses, taxes, etc. Very often, it leads to substantial overestimation of their income. Besides, it’s easy to make errors when you are working everything out in your head and not from accurate records.
When you don’t even know how much money you make, how can you do a good job managing it?
Calculating your average net monthly income
I know you don’t want this to be a lesson in accounting. It isn’t. Still, here’s what you can do. (All calculations below would be for the last month.)
- Sum up your total earnings — This is the total amount you received for the work done during the last month (do not include any advances paid for your future work or any payments for the work you had done earlier).
- Calculate your business expenses — This would cover every expense that helps you do your job or that you wouldn’t have if it weren’t for your business. Some examples — subscription fees for any service you use, travel costs, equipment costs, etc.
- Calculate the estimated tax due —You don’t necessarily need an accountant for this. With some understanding of taxation (something you must develop), you can do the monthly estimates yourself. Try to err on the higher side, though, it’s better to have too much set aside than too little.
- Get your net monthly income — Deduct the business expenses and the estimated taxes from your earnings, and you will know how much you made for the month.
- Take the average — The steps above would tell you how much money you effectively made last month. But they don’t take into account the expected fluctuations in your income. So as insurance against those ups and downs, you take the average of your net earnings for the last six months (or more, if you see large variations)
2. Big Check Syndrome
Even if you have a good idea of how much you earn every month, you can still fall prey to what Patrick Bet-David, founder of Valuetainment, calls the “big check syndrome”.
As a freelancer, it’s not unusual to have two or three great months every year in which you make more than all the other months’ earnings put together. There are many reasons why that could happen — maybe you finished a project and got paid for several months of work or received an advance for a big project. Or maybe one of your blog posts went viral.
Whatever be the reason, you must not make the mistake of treating a spike as the norm and spend all that money in haste. Or you will regret it for a long time. Those spikes form a small part of a larger cycle and make up for the many other months that may not be as good.
Create a salary account for yourself
I protect myself against the big check syndrome by having sort of a salary account for myself. Any money I make goes to a separate account. Once every month, I transfer my average net income from there to my “salary account”. All my personal expenses (including the recurring investments) except taxes, go out of my salary account.
3. Having No Emergency Fund
If you understand the rules of money, you know how important it is to save and invest.
Everybody needs to save. But salaried employees at least have the illusion of job security. If you don’t have a permanent job, you don’t even have the comfort of that illusion. I feel ashamed to admit that I didn’t seem to have this basic concept figured out when I started.
Anyway, the point is you need to build up 6–12 months of an emergency fund and have it in your bank account (that you don’t touch unless absolutely necessary) or some other form of liquid asset.
Not having such an emergency fund makes you vulnerable to all kinds of unexpected shocks and can push you into the debt trap. If nothing else, you will be forced to accept shitty jobs to stay afloat. It is among the factors that make self-employment stressful for many. So make sure you have some reserve.
Creating an emergency fund
Your first task is to figure out the minimum amount you need in a month to take care of your necessities and stay functional in your profession or business. If you can’t function, how would you bounce back? Once you have your monthly number, multiply it by 6 (or 12 would be even better). That’s how much you need in your fund.
For the next step, open a bank account solely for this purpose. Save as much as you can every month and transfer your savings from your “salary account” into this emergency account until you hit the target. That’s all there is to it. And yes, make sure you never forget it’s an emergency fund.
4. Not Hiring a Tax Expert
Look, if freelancing is your primary source of income (or significant enough), you’ve got to treat it as a business. That means unless you have the required skills and experience, you must seek professional assistance with things like accounting and taxation. At least for your annual and final figures.
A tax expert will help you get every deduction you are eligible for and minimize your tax obligations. They will save you both time and effort. And they will make sure you don’t make any reporting errors that get you in trouble later.
Also, depending on your location and circumstances, it might be wise to register a company and conduct all your transactions through that company. Again, a professional will help you make such decisions.
Hiring a professional
When hiring an expert, there are two things to be careful about.
One, they must be good and reliable. If you know someone you can trust (maybe a self-employed friend who has been doing this for a while), ask if they can refer someone. Or do some research yourself. Either way, make a well-informed choice.
Two, you don’t end up spending an unreasonable amount. One way to limit the cost is to hire them only for your annual filing. If they prove to be worth it, for the next year, you can hire them every quarter or whatever works best for you. If you do it well, the service will pay for itself.
In a Nutshell
If you are self-employed, it’s easy to make fatal mistakes with your finances. Add these four things to your financial routine to avoid the most common ones.
- Know your average net monthly income — your income after removing your business expenses and taxes.
- No matter how much you earn in any particular month or quarter, spend in accordance with your average from step 1.
- Have 6–12 months of an emergency fund.
- Hire a tax expert.