You closed that 7-figure listing. Your seller got what the price they wanted and the buyer was ecstatic to get exactly what they were looking for. Everybody is happy.
There’s only one problem. Now you have a large commission check coming your way and you aren’t sure when you’ll close your next deal. So, what should you do with that large influx of cash? You know you don’t just want to spend it, with the unpredictability of your income you know that would be foolish. So, what should you do? Let’s walk through an example to give you a better idea.
We’re going to assume that your emergency fund is stocked with 3 – 6 months of living expenses and that you previously set up a SEP IRA but haven’t made any contributions to it this year.
Let’s say after the split, your broker’s take, etc., you net $30,000 in commission from your listing. Let’s look at what you may do with that chunk of change. In order of priority:
Set money aside for taxes (25% = $7,500)
I know, I know…this stinks, but your first priority should be to set aside money to pay your taxes. As a 1099 independent contractor or the owner of your own office, your taxes generally are not deducted from your income like a W2 employee.
However, that doesn’t mean you don’t owe the tax. Therefore, you should be setting aside about 20% – 30% of your income to pay your taxes. Why so much? Depending on if/how you may be incorporated, not only do you owe income tax, you may owe self-employment taxes as well such as FICA and FUTA, etc (if you’re incorporated and taken the S-Corp election, you personally don’t owe self-employment taxes, but that’s a whole other can of worms we’re not opening right now).
So, what should you do with that cash until it’s time to cut a check to the government? You’ll want to keep it liquid in either cash or a cash equivalent. Primarily something that won’t lose value in the short term. For example, you may put it in a savings account or a money market mutual fund that could earn you a few percent in interest while maintaining easy liquidity.
You SHOULD NOT put that money into anything risky or illiquid. Don’t invest this money in the stock market. Stocks may be liquid but you could lose a lot of money in the short term. When it comes time to pay your taxes, the IRS isn’t going to care if you squandered your income on high risk investments. They want their money.
You should also avoid putting this money into anything that will lock it up past the date your tax payment is due. For instance, if your taxes are due in 2 months, don’t put this money into a 6 month Certificate of Deposit (CD) at your local bank. Sure it may be safe, but you can’t access the money when you need it.
Pay yourself a living wage (45% = $13,500)
Next, you want to set aside what you need to live. This amount obviously varies based on your personal situation. As a real estate pro, your income can be quite uneven, or as I like to call it, “lumpy.” So, we need to smooth it out.
This is where some level of analysis and planning is needed. A simple way to do this is to add up all your annual living expenses from the previous year, add projected additions/increases for the current year, and then divide by 12 to arrive at your maximum monthly living expenditures (food, shelter, transportation, etc.).
What should you do with this cash? You should treat it very similar to how you treated the tax money. Put it in a safe, liquid account that won’t lose value but may earn a small rate of return while sitting in your account.
Finally, and this is the most important part, stick to only spending your maximum monthly living expenses each month. Depending on your level of activity, it could be 1 month, 3 months, or more until you close on your next listing. Therefore, sticking to a disciplined spending approach is crucial in order to smooth out your lump cash flow and avoid costly financial mistakes.
Save for your future goals (15% = $4,500)
Since your emergency fund is already good to go, you’ll want to take this money and invest it for your long term goals.
If you have kids, this could be toward a 529 account to help them pay for college. If you’re looking to save up a down payment for a home, this could go toward that. If you’re looking to save for retirement, you could put this into your SEP IRA. You get the idea.
A good rule of thumb while investing for your future goals – the longer the time horizon is until you need to access the money, the more risk you should take. For example, if you’re 35 years old and want to retire at 65, you should probably be 100% invested in the stock market to help you build the long term value of your retirement accounts. However, if you’re 64 years old and looking to retire next year, you should probably have a much more conservative portfolio mix of stocks, bonds, real estate, and other conservative income producing assets.
In general, you should be striving to save 10% – 20% of your income for future goals. Even more so if you have multiple competing long term goals such as your kid’s education savings and your retirement savings.
Business reinvestment (5% = $1,500)
This is pretty self explanatory, but you want to ensure you’re reinvesting back into your business with every commission check you earn. Everybody is different so make sure you’re investing in the marketing and business development areas that provide you the best return on investment.
While this is important, it’s fourth on the list because you should ensure you’re paying yourself and your future first before reinvesting back into your business.
Whatever you want! (10% = $3,000)
After everything else is taken care of, whatever is left over is yours to do with as you will. Take the family to Disney World, buy that watch you’ve been ogling over for the past 6 months, fly to Iceland and hike through the glaciers, whatever you want. You’ve earned it.
However, if you’re anything like me, you’re probably sticking this money into your SEP IRA as well because you’re a weirdo when it comes to overly long term thinking.
Keep in mind that this is just an example breakdown of what you could do when you bring in that large commission check. However, you can expand this thinking to every single commission that you earn. While you can adjust the percentages to fit your personal situation and values, the order of priority should, in my opinion, stay the same.