Why Should I Care About Sinking Funds?
What’s cooking everyone! Today we’re jumping into the sexiest aspect of being a freelancing creative; personal financial discipline! Yup, widely regarded as the sole reason any of us wanted to jump into art in the first place, am I right?! Ok, maybe I exaggerated slightly, but it is a critical part of being a freelancer, as there’s no automation through our employer for things like retirement, health insurance, and withholding taxes to be taken out each paycheck. As freelancers, it takes discipline to manage those areas on our own, and since many of us tend to be right brained dominant, I think it’s even more critical for us to find easy and simple methods to manage our time and money.
Below I’ve made two charts to contrast; the red one shows a single bank account method of financial management I used for a long time right after college without any real thought. I gather many people use this method to some degree, maybe with an additional Savings account. The second chart, in green, shows a multi-account method that I believe organizes my money more efficiently and best prepares me for future expenses by splitting money and creating sinking funds. Let’s take a look.
As you can see, this first chart is pretty simple. When I receive a paycheck, it gets deposited into one personal Checking account, and every subsequent purchase or payment is made via that account. You may notice there’s a lot of things to pay for each month, and it’s all over the place. If you have kids, maybe double the responsibilities. If you have medical problems, double it again. My chart is a mix of personal and business expenses that I find pretty common and, of course, will change depending on the person.
It took a while for me to identify any issue with this method when I was working full time jobs, because I wasn’t carrying any balances on the credit card and my pay-stubs automatically deducted social security, taxes, and health insurance. But I realized through freelancing that this system gives me a very unrealistic perspective of the available finances I TRULY have, which can lead to overdrafts and penalties and more money wasted on high-interest rates. It can also prevent me from ever really saving anything, which is obviously important for things like homes, cars, kids, college educations, expensive equipment, etc. This is particularly problematic for freelancers, who have to deal with irregular income and quarterly self-employment taxes.
Let me put this in perspective using this red diagram. Let’s say I make $1000 from a job and deposit that check into my account. I purchase some things, take care of my bills, buy some food and groceries, and take the family out for a dinner or two. It doesn’t seem like I’ve spent extravagantly, but by month’s end, I honestly have no idea how much of that $1000 I spent without going through the CC bill and calculator. I might have spent more than that $1000. But I don’t truly have that $1000 to spend, do I? Being self-employed in California, it’s my responsibility to recognize upon payment that 27% of my income needs to get set aside for Uncle Sam, so I really only get $730. Just because $1000 is sitting in my account, doesn’t mean I have $1000. Now think about adding 5 more checks that month with not such easy, round numbers. And then fast forward 3 months, averaging a handful of jobs each month. Can you keep track of all this without some sort of system? Do you honestly know off the top of your head, how much you have available? See the problem here? It’s hard to keep track of. Most people hate looking at their finances. I’m just going to guess that most Americans look at them once or twice a month, so it’s likely that they have no clue where their money is going and what they have saved up. For me, it was so easy to get lost using this method. For instance last year my annual photography insurance payment coincided right around the time of my April 15th tax quarter and I had jobs that were a week late on payment, so I had to do some mental gymnastics going through my account to see what I actually had. I didn’t want to bounce a check or overdraft my account. Now, let’s take a look at the second chart below for a second and see how this method could potentially help.
As opposed to the one personal checking account in the red chart, this green chart shows 6 different accounts. Yes, 6. Stick with me here, it’s actually easier than it may look upon first glance and it doesn’t cost anything so long as you have a bank that isn’t trying to nickel and dime you with all sorts of minimums and fees. Some of these accounts are basic checking accounts, while some of them are savings accounts that I use as sinking funds. A sinking fund is just a term for setting aside money each month for a specific expense. Think of it like an online piggy bank.
Let’s take that same hypothetical $1000 check and deposit it into my personal checking account in the center of the diagram. I call this the GUTS ACCOUNT (Groceries, Utilities, Transportation, and Shelter). It’s got the critical things that I need money for; rent, food, gas, water, power. On average, I’m going to keep 40% of that check in there. Your lifestyle may be higher or lower. One little side note; I do try to keep 3 months of rent in there at all times for safety measures.
QUARTERLY TAXES: Now that the GUTS are budgeted for, I go counter-clockwise to the second priority, taxes. Of that $1000 paycheck, I’ll automatically transfer 30%, or $300, into it. If I do this consistently every paycheck, I never have to worry about not having enough come that time of year. I have this account linked to the IRS to automatically withdraw my estimates each quarter, so it’s important that I have the right amount in there, otherwise, I’d get penalty fees.
BUSINESS EXPENSES: Next up I have my business account, which is a liquid checking account where I’ve decided to allocate 10% to so $100 will get transferred in when I receive this check. This account is where I pull from for photography insurance, website hosting, subscriptions, marketing material, and gear. Now, I currently put a low percentage in there, so if I know I need to purchase a lens, a camera body, or something pretty expensive, I try to build up enough money in that account and pay for it in cash. Sure, it may take a long time, but it’s better than throwing big purchases on a credit card that I’m paying high interest on, so I’m fine with waiting. If I need something a little sooner, I may put 20% of that check in there for a few months and limit my grocery spending and things like that.
EMERGENCY FUND: Next up is the emergency fund, which is in a Savings account that is generating 2% interest. I ONLY use this for emergencies and hopefully, rarely have to down the road. At this time, I have $1000 in there, and as I continue to make more money, my goal is to carry about 6 months of living expenses in here as a preventative measure just in case I lose a big client, my wife loses her job, we get robbed, I total my car or anything of that nature. Having this gives me tremendous peace of mind.
VACATION FUND: The vacation fund is really putting aside money for fun stuff. You got to live too right? We don’t take a lot of trips, and certainly, I’m not putting enough percentage in here to fully fund a trip to France or Tahiti, but if I can put small percentages in each check, it gives us a little guilt-free spending cash that we know is designated for that trip. 5% from this job puts $50 bucks in. I’m happy with that. That’s a delicious Vegas buffet for 2 that I don’t feel guilty about…at least not yet.
RETIREMENT: The last account is another savings account for retirement. Ideally, I’d like to get this number to 15%, and that will happen in time. This account will not permanently hold my retirement money, because savings accounts are, at best, only going to return 2%. If you’re at a major bank, you’re getting pennies on the dollar. But by accumulating and storing some cash in here, I can then transfer this each month into a growth stock mutual fund that will eventually compound for the next 30 years at somewhere between 8-12% rate of return.
And that’s my system. Other than the tax folder, every account and sinking fund is negotiable in terms of how much I decide to put in. Maybe I don’t put any money into my vacation fund for a few months so I can put more into my retirement fund. Maybe I reassign the vacation fund entirely to a “New Car” fund. It’s totally up to me. The main point is by splitting my money, I’m more organized and don’t overdraft and spend more than I have.
Budgeting is certainly not sexy, I get that. But saving and growing money that you work so hard for is such an important skill set to freelancing. Maybe you have a better system that works for you, and that’s awesome. But a lot of people say “my system works for me” when it actually doesn’t. Are you saving more, are you building more, are you prepared for potential emergencies? Make certain your system actually is working and if it’s not, do something proactive about it. And don’t take my word for it. Read more, ask people who have built a great deal of wealth on how they manage their money. Whether you make $30,000 or $300,000 is of no consequence to me. Prepare yourself either way. A great many people have said before me, “Failing to plan is planning to fail”. Freelancing is a wonderful lifestyle. I want everyone to live their best version.