Budgeting for the unforeseen
As a freelance professional, you are largely responsible for “looking after number 1”, and in this article we set out some considerations for building in the necessary financial buffers and dealing with the unexpected. Although we do not like to think about it, an enforced absence from work could have a very serious effect on family finances. Steps need to be taken to plan for the unforeseen – a significant gap between contracts, or an absence caused by ill health for example.
1. Building an emergency fund
The first step is undoubtedly to build up an emergency fund – no more complicated than rainy day money. And the natural home for this should be easily accessed cash held within the company. Do not make the mistake of drawing large sums from the company simply to deposit in a personal bank account, thereby incurring unnecessary tax bills.
Company funds will allow you to continue to draw an income each month, even though you are temporarily not earning. There are no hard and fast rules about the actual amount you should set aside; however, as a rule of thumb it is usually recommendable to have enough to cover 6 months personal expenditure.
2. Considering income protection insurance
Income protection insurance pays out a continuing monthly income to you if you are unable to work through ill health. Any income paid is normally free of tax, and will continue until the policy end date – typically age 60 – or, when you are able to return to work. Once you are accepted by the insurance company, the policy cannot be cancelled by them, and in most cases the premiums cannot ever be increased, irrespective of how many claims you may make in the future.
A good quality income protection policy can be worth its weight in gold and should be given serious consideration, but there are a number of considerations and pitfalls here and unfortunately there are many policies that are unlikely ever to pay out, or are prohibitively expensive, for various reasons:
- If you are a contractor it is extremely unlikely that a policy will pay out if you become unemployed. In other words, you should only be paying to insure your income against being unable to work for health reasons, not for unemployment cover.
- You should only buy a policy that covers you on an “own occupation” basis. This means that it will pay out if you are unable to carry out your own occupation. There are many policies that have an “any occupation” definition which means that in order to claim you must not be able to do any paid job. As a freelance professional you are likely to have specialist skills, years of experience and be highly qualified, but such a policy would not pay out if the insurance company considered you fit enough to do the most menial of tasks.
- The “deferred period” has a huge bearing on the premium. This refers to the length of time you have to wait between becoming incapacitated and when the policy starts paying out. The real financial threat is being unable to work for an extended period, possibly for many months or even years. The premium for a policy with a 1 month deferred period is typically twice that of a 3 month policy, so I would recommend “self-insuring” the first three months at least, simply by leaving sufficient funds in the company.
- Be aware also, that the amount of income you can insure for is based on a percentage of the amount that you draw as personal income from your limited company, not the company’s turnover. Most insurers allow you to cover dividends as well as salary, but not all. Some, but not all, will also cover spouse’s dividends.
- Critical illness insurance is not the same as income protection. The former typically pays out a lump sum on the diagnosis but survival of a specified condition such as a heart attack, cancer or stroke, whereas a good income protection policy will normally cover all health risks and is therefore more comprehensive in nature.
- Accident, Sickness and Unemployment (ASU) policies, generally sold when you take out a mortgage or loan, is not income protection insurance. ASU policies only pay out for a limited period, are often written on an “any” occupation basis, and the unemployment part is unlikely to pay out if you work for yourself.
In summary therefore, the advice is to self-insure short term risks by holding an emergency pot in the company, and combine this with a good quality income protection policy to protect against the financial threat of longer term ailments. The latter is a specialist area, especially in respect of freelancers, and it pays to take independent advice.
Bill Saunders, Acumen Financial Planning, 01224 392350, email@example.comManaging your money