Here’s a fact – paychecks can be confusing, and often depressing. Why? Because when you work for someone else, the government slices off a huge chunk of your total pay — as much as 40% — or more.
We pay federal, state, social security, Medicare, and county taxes, and sometimes even commuter taxes. And then medical insurance and retirement savings take a final bite out of what eventually becomes our net pay – or take home pay.
In the last few posts I highlighted the benefits of using credit cards, planning your financial life quarterly instead of monthly, and gaining a better understanding of your spending habits.
Now I’ll show you how to bring home as much of your hard-earned pay as possible, and how to see if your expenses (in relation to your take-home pay) are reasonable, and how to think about your 401k differently.
Simple Advice on Taxes
The biggest tax everyone pays – regardless of who’s in the White House – is federal income tax. And back when I was in debt, and financially inept, I looked forward to my federal tax return each Spring. I would usually receive a few thousand dollars and it would bail me out of my latest financial quandary.
But in reality, I was letting the government take more of my money than they required. Even worse I was letting them hold it for months without paying interest. The government wouldn’t loan me money interest free, nor would a bank. So why should I?
This is why a business hires accountants and bookkeepers. They want to minimize the amount of money they pay each year in taxes. Their goal is not to have a big tax return, their goal is to actually owe a little bit of tax.
Why? Because those extra dollars over the course of a year — in my case thousands of dollars — could have been invested, saved or used to pay off interest bearing debt. Getting a large tax return is a sign that you didn’t maximize your cashflow, it’s a sign you don’t have self-mastery over your own finances. And it’s something easy to fix.
So, where do we start? Well, start by adjusting the exemptions on a W-4. This is an official IRS form telling your employer how much tax to withhold from your paycheck. These exemptions are based on your marital status, number of dependents, and other factors. Your human resource department can easily provide this document, or you can download one from the IRS website.
The question on your mind may be how many exemptions should I take? The answer is, it depends. Everyone’s situation is different, but you don’t have to guess. Check out this easy withholding calculator from the IRS, all you need is a recent paystub:
Here is one of my actual pay stubs from 2019.
I’m claiming 4 federal exemptions, and 2 state exemptions. And I’ll admit, this is aggressive. It’s more than the IRS website indicates I should take. But my situation is unique because I have deductions outside of work further reducing my taxable income. My number of exemptions allows me to maximize my take home pay without exposing myself to a huge tax bill each Spring. If you have any doubt about how many exemptions you should take, invest a few dollars and seek professional advice from an accountant.
One day while looking over my latest paycheck, I wanted to measure the impact of each deduction and expense in relation to my income – and once again – I couldn’t find a resource like this anywhere. So, I created another spreadsheet, I call it my Paycheck Alignment Tool.
Here I go again, more spreadsheets! Hang in there with me. The point of this chart is to see what percentage of my income was going to various categories; savings, taxes, insurance and all expenses. My goal was to maximize savings, especially pre-tax savings like my 401k, and to make sure I wasn’t spending too much of my income in any particular area.
The far-left hand column lists the standard deductions anyone who works for someone else sees on their paycheck. The rest are my personal expense categories pulled from the Quarterly Cashflow Planner.
The deductions in green are my pre-tax savings and are the most important. The best use of this tool is to see how big of a benefit pre-tax savings are on my entire financial universe.
The column in the middle, Monthly Gross Pay, is where I combine both my paychecks into one, and the spreadsheet automatically deducts the expenses from the left column while indicating their percentage impact in the column on the right.
What drove me into debt was when my fixed expenses like rent, utilities, food and transportation exceeded 50% of my take home pay. There is a lot of bad information (from biased sources) about how much of your income should go to the major expense categories.
Ask a mortgage company or real estate salesperson or bank and they’ll say 28-36% of your GROSS income is a comfortable range.
But in reality, none of your budgeting should be based on GROSS pay, only take home pay. And the wisest advice on rent or mortgage (as a percentage of your income) I learned from Dave Ramsey, the famous personal finance author and radio host – he advises your mortgage or rent – including taxes and insurance – shouldn’t exceed 25% of your take-home pay.
As I write this in November of 2019, my gross income per month is $9,690. I contribute 20% to my 401k and 2% to my Health Savings Account (HSA) which also gets the pre-tax benefit. This reduces my taxable income by $2,135 – so in addition to saving over two thousand dollars per month I lower my taxable income by the same amount. Further down the chart you see after all the deductions my take home pay is $5,290 per month. And of my take home pay, 26% of it goes towards my rent payment.
The Greatest Tax Loophole for Employees
The greatest advantage of plotting your income and expenses on this spreadsheet is to realize the power of pre-tax savings. The most beneficial way for an employee to reduce their taxes is by contributing as much of their paycheck to whatever tax advantaged savings plan their employer offers – most commonly a 401k savings plan.
This is the single most important piece of financial advice for anyone who works for someone else. The biggest obstacle to wealth isn’t just self-mastery over our personal finances, the biggest challenge to becoming wealthy are taxes.
Business owners have a huge advantage over their employees. They get to pay for many of their expenses before they get taxed, thereby reducing their taxable income. Employees have to use after-tax money – you know – the 50 or 60% we take home after the government takes their share.
When a business owner earns $100k she doesn’t have to pay taxes on the full $100k. She gets to pay her business expenses before establishing her taxable income. And many of those expenses cross over into her personal financial life – like her transportation, some food and travel expenses, and insurance.
After she’s paid those expenses – let’s say they added up to $25k – then she declares her income of $75k and THEN she pays her taxes in April. Let’s say taxes and insurance equal 40% so she’ll take home 60% of the $75k – or $45k – and pay $30k in taxes.
Employees do the opposite. If they earn $100k (assuming again taxes and insurance equal 40%) their taxable income is the full $100k. Meaning they’ll pay $10k more in taxes than the business owner who earned the same income, and if expenses are the same in the earlier example, the employee will take home $10k less in income.
This is why the 401k is the most powerful tax benefit for employees.
Why? Because the government allows you to automatically deduct up to $19,000 (in 2019) — prior to being taxed — to be invested in a retirement savings program (like a 401k).
But most people under-save and fail to take advantage of this tax break because it reduces their take home pay.
But over the course of a year, the reduction in take home pay is very minimal. While the upside to the tax benefits is exponential. Here are two scenarios I hope illustrate this point:
Option 1: Don’t Contribute
Let’s say you earn $100k per year and for simplicity we assume again taxes and insurance eat up 40%.
So, under this scenario you take home $60k, and pay $40k to the government — and save nothing. And after taxes you bring home (or net) $5k per month ($60k/12 months = $5k)
Option 2: Contribute just 10%
Now, let’s say you contributed just 10% ($10k) of your gross income ($100k) to your 401k pre-tax savings. This reduces your taxable income by $10,000 — from $100,000 to $90k, and with taxes and insurance at 40% — instead of paying $40k in taxes — you instead pay $36k in taxes ($4k less).
You might assume your take-home pay will drop by $10k — but it doesn’t — your take home pay only drops by $6k, from $60k annually to $54k annually, because you paid less income tax.
Your take home pay does go down from $5k per month to $4,500 per month ($54k/12 = $4,500). Granted, that’s $500 out of your pocket each month. But the government isn’t getting the difference! You are! Whenever you can save $10k by only investing $6k of your take-home pay — you should do it.
Let’s review the benefits of setting aside just 10% of your pay in this scenario:
- Paid $4k less in taxes
- Saved $10k by reducing your take home pay by only $6k
- A gross benefit of $14k by contributing 10% to your 401k
The other significant benefit of the 401k is the automatic deduction from your paycheck, meaning you don’t have to touch it, and you can’t touch it, or you will face significant tax penalties. Don’t underestimate the power of automatic deductions. We’ve all heard the axioms about paying ourselves first, but in reality, the 401k is the only tool that enforces this philosophy with teeth. If left up to our own devices, we often don’t save as much of our take home pay as we should. Life is just too tempting.
If you raid your 401k before you’re 59.5 years old the IRS will tax you at your regular tax rate plus an additional 10% as a penalty. The net result is almost half of your hard-earned savings will go back to the government. I should know because I made this mistake in my twenties. The money I withdrew would have grown into six figures by the time I am writing this in 2019. It was a stupid, stupid thing to do.
In my next post I’m going to touch on one of the biggest barriers to accumulating wealth, something that catapults millions of people into financial slavery, an industry supported by more disinformation and marketing than any other but the automobile industry, and that is the mortgage industry.