Most businesses have no strategy when it comes to paying themselves. Some businesses take random amounts of money out of their business when they need it. Some don’t draw any boundaries between business and personal accounts and instead take funds from either account whenever it’s necessary to improve cash flow on one end or the other.
Good, successful, and sustainable businesses, however, not only create a firewall between business and personal spending, but they create a strategy for paying owners.
Here are some tips for figuring out how and when to pay yourself.
When to Start Paying Yourself
I’ve written in other articles about how businesses that focus on costs and profitability (not revenue) are the most successful. In fact keeping costs under control is the best way to make sure you can get paid what you’re worth AND that you can pay yourself in a predictable way.
Once your business starts turning a book profit (revenue – minus expenses = extra money leftover which is profit), that’s when you should start paying yourself.
In the early years this could be small. Perhaps you only make $10,000 in your consulting business once you pay for wear and tear on your car, your business insurance policies, your computer, a desk and chair for your office, meals during travel, etc. That $10,000 is available for paying you a salary, but it doesn’t necessarily mean that 100% of it should be paid to you in salary. You have to consider creating some financial buffers to help smooth out your income, pay taxes, and save for retirement too (see below for targets).
After you’ve been around a while, you can pay yourself more. As your business grows and becomes more successful, your salary should reflect your hard work and success. You should eventually be getting paid at least a market rate for what you’d have to pay someone externally to do your job. You can also eventually pay yourself a “bonus” or “draw” of profits from time to time as well.
How to Pay Yourself
If you are a sole proprietor or LLC you can pay yourself by simply transferring money via ACH from your business account to your personal account. Simply login to your business bank account and set up a transfer schedule to push funds from your business account to your personal account. You are also allowed to pay employees and contractors by making transfers directly to them as well. Sometimes owners use a third party payment system others set up a direct transfer through the bank to pay employees or contractors.
If you are a corporation (C-Corp or S-Sorp) or an LLC filing as an S-Corp you must run payroll to pay yourself as well as your employees. You will need to employ a payroll service or administrator to handle this for you. Contractors may still be paid through direct transfers.
How Much To Pay Yourself
In order to figure out how much to pay yourself, you’re going to need to estimate your income and expenses for the year. Profit left over is available to pay yourself. Then you can divide that by 12 and you have a rough idea of what you can pay yourself. This is easier for an established business than one that’s in its first few years.
As you’re building your business especially, you should only pay out only a portion of your profit. The rest should be used to build up some cash cushion with your operating expenses so that you can weather uneven income streams. You should hold back about 5-10% of your profit to build these buffers.
If the type of business you’re in makes it difficult to come up with an estimate of how things will go for the year, then look at it on a quarter-by-quarter or month-by-month basis. Use the previous month/quarter as a guide (not the current one).
- Say your profit for last month is $10,000.
- Keep 10% or $1,000 to build up your cash buffers.
- That leaves you with the potential of paying out $9,000 in salary.
But wait, we need to set aside funds for taxes and retirement. When you plan ahead for these two things you won’t be caught off guard come tax time. This will prevent you from using next year’s profits for these items so you can pay yourself more as your income grows instead of always being reactive to what your CPA says you need to pay for taxes or for retirement.
My rule of thumb is to set aside 30% of profit for taxes and 25% for retirement. Then you can pay yourself the remaining 45% as salary (this is similar to take home pay as an employee). Really, the total value to you as the owner is 70% of profit — you’re just sharing part of it with your future (retired) self.
Taking our example above.
- You have $9,000 available to pay out as profit in a typical month.
- $2,700 of it should be held back in a savings account for your next quarterly tax payment (30%)
- $2,250 should be held in an account to make your retirement contribution at the end of the year (or via paycheck if you do payroll). (25%)
- And you can feel very comfortable paying yourself $4,050 as salary. (45%)
Why save so much for retirement? It’s tax-deductible (which saves you money in taxes), it’s a way to make sure your business creates wealth for you outside the business itself, and it ensures you’re planning for your future self.
As a business owner, you have the ability to contribute to a self employed retirement account such as a SEP IRA or Solo 401k. The maximum you can contribute per year is $58,000 in 2021. As an employee you are capped at contributing $19,500 plus a few thousand that your employer might kick in for a match. It doesn’t take a lot of math to see you have the potential to create a significant amount of wealth by focusing on retirement savings and following this method for planning ahead.
Fine Tuning Your Paycheck
You can fine-tune these target percentages depending on your tax situation (married versus single, your state’s tax rate, etc.) and your own retirement needs. If you’ve been a diligent retirement saver for more than a decade and you’ve done some analysis to see where you benchmark relative to others in the same age and income brackets, you may be able to save less toward retirement.
This is rare.
In my experience, most people, even high earners, are behind in their retirement savings. Setting up the expectation that you will save ahead for retirement from the beginning is a great way to set yourself up for success in the short term as well as the long term.
Selecting a Pay Frequency
For most businesses and owners, it makes sense to pay your base salary on a monthly basis. As you start making enough to pay yourself a bonus or draw, then you can do those transfers once a quarter, twice a year, or even one time at the end of the year. You will only pay yourself a bonus if the buffer in your account is high enough to warrant paying out a bonus.
If you must run payroll, then it’s a good idea to coordinate with your financial planner, CPA and payroll company to decide how often to pay yourself.
How to Handle Salary When Income is Uneven
Most businesses have uneven income streams. It’s not unusual for a business to make 40-50% of their income for the first two months (or last two months) of the year depending on seasonality. Other businesses depend on contracts and payments coming in which can often be unpredictable. Other businesses might only get paid from clients/customers four or six times per year. Expenses, too, are often irregular. So, you’re going to have to plan for this irregularity.
Inspired by ideas and concepts from Mike Michalowicz’s book Profit First, here’s how you should handle this:
Create three accounts:
- one for operating expenses (this is where all revenue comes in and expenses go out)
- one for tax payments
- one for owner’s pay, retirement, and profit
- you have the option to create a 4th account for retirement savings if you need this visual representation of savings. But sometimes keeping track of more than 3 accounts gets tedious, especially if you involve a bookkeeper.
- Otherwise, the balance in this account dedicated to retirement will accumulate until you transfer funds into your retirement account once per year (after getting the final suggested amount from your CPA).
After you pay all your business expenses each month, and set aside funds for taxes, you can sweep funds from your operating expenses account to your profit account. Watch as that balance grows.
Then once per month, you take your owner’s pay out of that account. It’s best to commit to an owner’s pay amount monthly and only update it once per quarter at the soonest. If you only get paid certain times of the year, then divide that revenue by the number of months until you expect to be paid again — that’s a good target for your monthly pay.
Keep sweeping funds after paying taxes and operating expenses into your profit account. The balance of your profit account will fluctuate – but if you’re paying yourself correctly, will never be overdrawn.
You can increase your monthly salary in increments as you hit certain revenue thresholds. Perhaps you keep a level salary for three months, and then if your revenue growth sticks for that long you consider raising your salary for the next three months. Another example where this works is if you get a new long-term contract with guaranteed income — you know you can raise your pay.
Keep a buffer of cash in each of the three accounts.
- In your operating expenses account you should keep a buffer of 1-2 months worth of your typical business expenses.
- Your owner’s pay account should have 2 to 12 months worth of your salary payments (depending on your business and the revenue fluctuations you experience).
- For instance, if you pay yourself $4,000 per month, then you should keep a minimum of $8,000 as a buffer in this account.
- You can increase this buffer depending on the variability you’ve experienced in the past.
- That way if you ever lose a big client, a client doesn’t pay, or something else impacts your income, you still have some funds available to pay yourself for a few months.
- Your tax account doesn’t need as much of a buffer as long as you’re saving up in advance for your taxes based on profit. But it should have a buffer of at least a few thousand dollars to account for the unexpected.
If you start with my recommended percentages, as you fine tune your exact percentages, you will naturally build up extra buffers in your operating, tax account, and profit accounts. These buffers will act to smooth your revenue and expenses because you’ll have enough on hand to 1) keep running the business 2) keep paying your taxes 3) keep paying yourself even if you experience a drop in income. This avoids having to go into debt or use future revenues and profits to pay for current year expenses.
Paying Yourself a Bonus
As you get used to the system and the buffers in your profit account builds, you should feel comfortable paying yourself a bonus. Let’s say you earn a few thousand extra two months in a row. Over the quarter you build up an extra $4,000 in your profit account. At the end of the quarter if you haven’t had to dip into your buffer to cover your owner’s pay, you have an extra $4,000 to pay yourself as salary. Since you’ve already withheld enough taxes for this revenue and set aside funds for retirement this can be paid as pure bonus funds to you.
What do you think, do you have other questions about how to pay yourself?
