‘Lumpy earnings’ refers to meaningful compensation that doesn’t come regularly, such as bonuses or commission.wutwhanfoto
In The Globe’s On Money personal finance newsletter, reporter Erica Alini looks at how to budget and plan for unexpected financial windfalls.
There is little advice out there on how to budget and save when your incomes ebbs and flows, as it does for so many people. One certified financial planner who’s been tackling the topic is Aaron Hector, co-founder of Calgary-based TIER Wealth, a partner of Q Wealth Partners.
Here’s an e-mail Q&A I did recently with Mr. Hector on how to make the most of what he calls “lumpy earnings.”
Q: Please explain: What are “lumpy earnings?”
A: Lumpy earnings is any type of meaningful compensation that is not received on a regular basis. Examples would include employees with bonuses that are paid annually, realtors and other commission-based positions where significant income is received after a deal closes or a sale occurs. People who have stocks as part of their compensation can also be in this group.
Q: How often do you come across clients who have lumpy earnings, and what do they typically struggle with?
A: It is very common. I would say that the majority of my working-age clients have some form of lumpy earnings. Many people have bonus structures that are paid annually. As people reach higher levels of seniority within a firm, the lumpiness of their earnings tends to also increase. Once people reach senior positions, a staggering of short-, medium-, and long-term incentive plans (lumpy plans) is common, in addition to a salary.
I often see people use their bonus as a get-out-of-jail free card. Throughout the year, they spend beyond their regular salary and rack up credit-card or line-of-credit debt. They then use their bonus to pay down their debt. It can be a vicious cycle that makes it hard to get ahead, and if the bonus is less than expected then it can cause someone to really fall behind.
Another tricky situation occurs when the lumpy earnings don’t have regular tax withheld. For example, some employees are granted shares that won’t vest until years later. Vesting marks when the shares truly become the property of the employee, who can do what they want with them. That’s also when the value of the shares would be considered employment income subject to tax.
Not all employers, though, withdraw tax when the shares vest. This can result in a large, surprise bill for the employee when they file their tax return for the year.
Finally, just not knowing what to do with the lumpy earnings, or not having a proper action plan in place for when that time comes, is another common struggle.
Q: What’s the right way to budget knowing that you’re likely to get some larger lump of money at some point in the year?
A: Rather than overspending for the majority of the year and then using a lump sum to climb your way out of trouble, it is much better to spend within your regular and consistent take-home pay. Then when the lump sum comes around you can do something truly productive with it, like taking advantage of pre-payment privileges on your mortgage, investing in your retirement accounts, paying off a car loan, or investing in yourself by paying for a continuing education program.
Q: Can you turn a lumpy income to your advantage? Can you give us some examples?
A: You absolutely can. Many people are poor savers, just look at the statistics on how many people live paycheque to paycheque. Imagine two people who each earn $100,000 per year. The first has a salary of $100,000, and the second has an $80,000 salary with a $20,000 bonus.
If they both get into a habit of spending their regular salary each month, then the second will have an opportunity to do something wise with the $20,000 bonus. After tax, that would be enough to top up their TFSA ($7,000), make a RESP contribution for a child ($2,500), and fund a continuing-education program which may lead to further pay increases and career advancements in the future.
Alternatively, rather than receiving the $20,000 bonus to their bank account, which after payroll deductions may be around $14,000, they might be able to ask their employer to direct the entire $20,000 directly into a RRSP account, which is a highly efficient way to save for your retirement.
A smart forward-looking move for first-time home buyers expecting a bonus or other “lumpy” income early in the year is to open a First Home Savings Account (FHSA) in the previous calendar year — even if you can’t fund it yet. Contribution room only starts accumulating once the account is opened, so this simple step could let you contribute $16,000 instead of just $8,000 when the funds arrive.
Do you have thoughts on how to manage lumpy earnings? Drop me a line at ealini@globeandmail.com.
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