Congratulations. You’re now a successful entertainment professional. You have a lawyer, agent, and manager (LAM) to help steer you toward the right projects and you’ve established an S-Corporation to channel your earnings. Now, you just need a system for handling all this income so you don’t end up financially scattered, confused, or worst of all, broke.
Despite the sting of a larger tax bill and roughly 25% of your gross income going to team LAM, you’ll soon end up with more cash in the bank than you’re used to having (unless you’re following the Johnny Depp spending playbook). Before you go on any spending sprees, it’s a perfect and crucial time to assess your long-term priorities:
- How much savings will you need to support the lifestyle you’re about to live?
- How much do you need in the bank in case there’s a big gap between projects?
- How much of your surplus income should you spend or save for short- and long-term goals (i.e. nicer home, kid’s college, retirement, etc.)?
If anyone needs a system for establishing reserves, saving, spending, and investing, it’s an entertainment professional. Let’s take Stewie, a 40-year old actor. He’s had a few great years, owns his home, and is ready to think about the future. He has no clue when he wants to stop acting, but he’s well aware big-paying projects likely won’t last forever.
Stewie would like for his nest egg balance to reach $5,000,000 by his early 50s, that way he can live off the portfolio and enjoy the freedom of choosing projects without worrying about the pay. We agreed on that figure as he feels $150,000 per year is sufficient to achieve his version of a minimum lifestyle once he’s in his 50s. He’s comfortable drawing 3% of his balance as an “income” stream ($5,000,000 x 3% = $150,000), but he fully intends to keep doing what he loves for as long as he loves what he’s doing.
So, what will he do with surplus income when his earnings are high? Stewie will have 5 key “buckets” in his life. A bucket is usually a type of account, but for the sake of this system, all tax-deferred retirement accounts will count as one bucket. First, I’ll provide a bucket tour, and then outline the system for how to shift your earnings into each one as money comes in.
Bucket #1: Business Bank Account for Taxes
Imagine your earnings flow to you through a multi-level fountain. At the top is taxes. As income arrives, you should move a portion of every check to a business savings account and leave it there until your accountant is ready to pay taxes. Your accountant can help you figure how much to set aside.
Let’s say 20% of your gross income is what you agree to. Remember, your tax rate will be calculated after many business deductions are factored in, including your retirement account contribution (in case you felt that 20% number seemed low). To reduce your accountant’s stress level, round up, not down. If you have too much money in there come tax time, you can always move surplus cash to another bucket.
You and your accountant might not pay your taxes until the end of the year. As an S-Corp, you’re permitted to pay taxes all at once as a withholding from the salary you pay yourself. Setting aside tax money as it comes in will ensure you don’t accidentally spend money earmarked for Uncle Sam.
Bucket #2: Personal Bank Account for Cash Reserves
So, how much cash do you really need to keep in the bank to survive those slow periods? My advice for most people in the entertainment business is to start with a cash cushion roughly equal to a year’s worth of expenses. If you have an investment portfolio that’s accessible for emergency situations (see Bucket #4), it may be okay to reduce your reserves target. (I’ll discuss a way to systemize project-oriented vs. annual income shortly).
Bucket #3: Business Bank Account for Retirement Contribution
Unless you have employees, you’ll want to establish a solo 401(k) plan in the name of your S-Corp. If your accountant suggests a SEP IRA, have them talk to your advisor. These plans have a few additional benefits, including the option to add a spouse to payroll and make a contribution on their behalf. In order to keep the math extra simple, I use $50,000 as a target amount to put in this bucket before year’s end, but your actual contribution may be much higher or lower. Regardless, you’ll want to max this out every year.
If you have an insatiable appetite for paying less tax, and you still have cash laying around after filling up Buckets #1 and #2 (and covering your essential expenses), talk to your advisor or accountant about adding a defined benefit plan to the mix. It will put you on the fast track to a much-accelerated financial freedom date. For example, if half your income goes to taxes, a $100,000 contribution to one of these accounts could lower your tax bill another $50,000. Every tax dollar saved is a dollar you can put towards another goal or invest (see Bucket #5).
Bucket #4: Personal Checking Account (for Spending)
This bucket is one you’re already familiar with – it’s your personal checking account and where you should pay all of your bills from. Your business bank account should only be a temporary holding tank to receive earnings before you quickly transfer that money to other buckets – ensuring all of your dollars are given a purpose before you find yourself hoarding cash or overspending.
As mentioned, before you can systemize a saving and spending plan, it helps to have a ballpark figure in mind for what a typical year of spending looks like for you. Web-based tools such as mint.com are a good place to start, or you can review your year-end credit card statements. For me personally, I try to imagine how much I’d need each month from my portfolio – at a minimum – to know whether I could leave my job if I was no longer happy. My definition of minimum would be I don’t feel constrained, but I also can’t just buy whatever I want.
The good news is you don’t necessarily need to create a budget using this system (I’ve never had one). For Stewie, his minimum comfort number is $150,000 per year, or $12,500 per month. (Happiness can occur at lower numbers, so please don’t judge Stewie.) Knowing this figure helps greatly in two areas – to determine how much to keep in Bucket #2, and how much to invest for the future in bucket #5.
Bucket #5: Taxable Brokerage Account
Forgive the lingo, but we advisors often refer to any account without tax-deferred growth as a “taxable” account (because you’re paying some taxes along the way on dividends, interest, and any selling that happens). You’ll usually put this account in your name, or hopefully, in the name of your living trust (yes, you should have a living trust – unless you don’t own any real estate yet). If you fill up Buckets #1 through #4 and still have some left for Bucket #5, congratulations! You’re on your way to a seriously early financial-freedom date and deserve an award for being a rock star saver!
Systemizing Your Saving and Investing
Stewie uses 6-month windows to see how much surplus income he’ll have left after filling up Buckets #1 through #4. Because he’s confident about his ability to earn at the moment, he likes to keep 6 months of expenses in Bucket #2 and hopes he never has to touch it. Since he’s already filled Bucket #2, he needs to figure out how much of his earnings to allocate between Buckets #3 and #4.
Stewie recently signed on for another season with his TV show and expects to earn at least $500,000 between January and July. After paying his professional team and setting aside 20% for taxes in Bucket #1, he moves the next $50,000 to Bucket #3, (earmarked for eventual Solo-K contributions now). He takes the remaining $225,000 as it arrives and moves it to Bucket #4. From there, he’ll pay all his expenses, including credit card balances, in full every month. He will end up with an extra $100,000 by the end of June. Since he has no other short-term goals to apply this to, he adds that $100,000 to Bucket # 5.
Some people may prefer to take a percentage of each paycheck and allocate it to Buckets #3 and #4, much like an employee does in a traditional job with a 401(k) plan. Regardless, come July, he’ll go through the same process all over again. If he’s facing a few months with no income, he’ll draw from Bucket #4 for up to a year and cut back on spending if he wants to extend his “runway.” If he’s running on fumes, he’ll have to raid Bucket #5. If he’s still tapping into Bucket #5 for more than a year, he may have to do some soul-searching on life in “the biz” or earn income in some other way.
Is it Business or Personal?
Stewie uses a business credit card for anything he believes will be eligible for a business deduction and a personal card for stuff he knows isn’t. But, he pays both cards off from his personal checking account so it’s easier to focus on his total spending estimate.
When Stewie isn’t sure if an expense will be deductible, he puts it on the business card since it’s easier for an accountant to remove non-deductible expenses than hunt you down for expenses you may have forgotten to include. If you get no joy from trying to keep your business organized, hire a bookkeeper or ask if your accounting firm can add this service.
Living in the Now
What if you don’t want to save your surplus income? You’ve had a killer year and you want to enjoy it. A good guideline is if you’re at least maxing out to Bucket #3 then it may be fine to enjoy some of the perks of your big year instead of filling Bucket #5.
One option? After a 6-month period, take some percentage of your Bucket #4 surplus and treat yourself to that kitchen renovation you always wanted, a fancy car, etc. You could also knock out one of your big-ticket goals, such as fully funding a 529 account for a child’s college costs. You’ll have to strike the right balance between living in the now and how quickly you want to build your nest egg to a level where you can start living off of it.
Real World Application
For simplicity’s sake, I assumed Stewie’s salary was equal to his net profit. For most people with an S-Corp, some of your profit will pass along to you as a dividend, which may lower your overall tax bill a bit. You can let your CPA work out that part.
The timing of when you actually pay your taxes and contribute to investment accounts will vary. Your CPA and advisor should regularly communicate with each other, so the left hand is talking to the right hand about what system is being set up. For example, Stewie’s CPA declares a salary in December; at the same time, he defers a portion of his salary to complete one of two 401(k) contributions. He writes a check from Bucket #3 for this deferral and then makes a second contribution once the accountant approves it (closer to the tax deadline).
Remember, as long as you’re following the system and setting enough aside for the most important buckets (#1 and #3), you don’t need to wait until a salary is declared to move money into your various buckets. Your accountant, like your advisor, doesn’t want you in a pickle at tax time.
Congratulations, you’re not only a working entertainment professional, you’re also financially organized. Before you get too deep into your Hollywood success story, create the right systems and a stellar team at the outset. You’ll minimize mistakes, maximize your tax deductions, and have more time for your craft and your family.