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Maximizing Cash Flow Part 3: Paycheck Alignment

Here’s a fact: Paychecks are confusing, and often depressing.  

Why? Because our government lops off a huge chunk of every paycheck we receive — as much as 40% — or more.   

There’s federal income tax, state income tax, social security tax, Medicare tax, county taxes, and sometimes even commuter taxes.  And don’t forget medical insurance and retirement savings.  

In my last two posts (see links below) I highlighted the benefits of using credit cards and having 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, how to think about your 401k differently, and how to make sure your fixed expenses (in relation to your take-home pay) are reasonable.    

Simple advice on Taxes

The biggest tax we all pay regardless of who’s President is federal tax.  And when I was deeply in debt, one thing I always looked forward to each Spring was my federal tax return.  Sometimes it would be thousands of dollars.  

What I didn’t know is it’s better to NOT get a tax return, and in some cases, its better to PAY a (little) money back to the government each year.  

Why? Because the government doesn’t pay us interest on the money they withhold. Those extra dollars over the course of a year — sometimes thousands of dollars — could have been invested, saved or used to pay off debt.

It’s up to you and me to make sure we take home as much of our pay as possible. Because if we leave it up to the Federal Government, they’ll take as much interest free money they can get their hands on.    

The W-4

So, where do we start?  Well, we start by adjusting the exemptions on our W-4.  Your human resource department can readily provide this document and change it for you at any time.  And it will determine how much they deduct (from each paycheck) in federal and state taxes. 

Ideally, this is done correctly when you start any new job.   

Above is an actual paystub from when I lived in Boise, Idaho.  And this represents an optimal number of exemptions for me at the time, allowing me to take home the maximum amount of money without overdoing it.  I was single, had no dependents, was renting an apartment, and was paid bi-weekly. So, I claimed two exemptions for both federal and state taxes.    

Everyone’s situation is different, and the amount of exemptions will vary depending on if you’re married, have kids, and how often you get paid.  

Good news, you don’t have to guess at this.  Check out this easy withholding calculator the IRS provides in this link:

All you need is your most recent paystub.    

The Only (Legal) Way to Reduce Your Taxable Income AND Save Money

There is only one legal way to reduce the amount of federal and state tax you pay, without reducing your income, and that is by contributing as much of your paycheck as possible to your 401k retirement savings plan.

This is the most powerful tax benefit in the entire universe of personal finance.  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.  

I get that, and many respected personal financial advisors will suggest a pause on retirement savings until all debt is paid off.  

I don’t disagree.  But the reality is, over the course of a year, the reduction in take home pay is very minimal.  You’ll barely notice it.    

Option 1: Don’t Contribute

Let’s say you make $100,000 per year and for the simplicity’s sake your tax rate is 25%. 

So, under this scenario you take home $75,000, pay $25,000 in taxes — and save nothing in your retirement account. And after taxes you bring home (or net) $6,250 per month.   

Option 2: Contributing

Now, let’s say you contributed just 10% of your gross pay ($10,000) to your 401k program. 

This reduces your taxable income by $10,000 — from $100,000 to $90,000, and at a tax rate of 25% — instead of paying $25,000 in taxes — you instead pay $22,500 in taxes ($2,500 less). 

You might assume your take-home pay will drop by $10,000 — but it doesn’t — you bring home $7500 less per year, not $10,000 less. Your annual take-home goes from $75,000 to $67,500.

Your take home pay does go down from $6,250 per month to $5,625 per month.  Granted, that’s $625 out of your pocket each month.  But the government isn’t getting the difference!  You are!  Whenever you can save $10,000 by only investing $7,500 — you should do it.  Let’s review the benefits of setting aside just 10% of your pay in this scenario:  

  • Paid $2,500 less in taxes
  • Saved $10,000 in your retirement account
  • A gross benefit of $12,500 by contributing 10% to your 401k

Health Savings Accounts have the same impact, they are shielded from taxes until you retire, so it’s a smart cashflow move to reduce your taxable income by as much as you possibly can. 

Fixed Expenses in Relation to your Take-Home Pay

What drove me into $250,000 in debt was the accumulation of too many fixed expenses in relation to what I was earning.  Problem was, I had no way to visualize my expenses in relation to my take home pay.  

I wanted a better way to see how my paycheck was allocated starting with my 401k, HSA, taxes, fixed expenses and then my variable expenses.   

This would help me understand where everything was going, and what levels were ideal in each category in relation to my take-home pay.   

Mint was great, it helped me realize what I was spending — but didn’t give me the vision I needed.  So, I created my own Paycheck Alignment Spreadsheet.  

This tool, along with all of my other spreadsheets and tools will be available for download at the end of this series on Cashflow Optimization

As you can see at the top I was grossing (on average) $6,000 a month through my commissionable sales job.  I was making plenty of money especially for a single guy living in Indiana, but I was blowing through it just as fast as I was making it.

How a Moron Spent Money

My fixed expenses were over $3,000 — practically consuming my entire take-home pay. 

By the time, I paid off my regular bills I was out of money.  But I kept on spending!  Food, booze, gambling, golf, clothes etc.  I kind of knew this — but not to the full extent — not until I plotted it on this chart, and it helped me wise up quickly.    

I became determined to get out of debt and move into a cashflow positive situation. So I sold my house and moved into a rented condo, paid off my car, paid off my credit card debt, stopped going out to the bars, and consolidated my personal financial lifestyle to maximize my cashflow and savings.

My fixed overhead went from over half my pay to less than half my pay. And that really was the secret sauce because everything else I could adjust on the fly.  

And in just a few years I was able to pay off over $250,000 in debt. 

As you can see below, my income in commission sales grew substantially as I found more success at work.

This represents my personal financial status about 2 years after I climbed out of debt while I was still working in commission sales.

Once I began the mission of changing my personal financial life, my success (and focus) at work sharpened

Earning more income was critical to my success of getting out of debt — but, without better vision into how much I should be spending in all of the major categories, I wouldn’t have dug out of my situation so quickly.

In my next post, I’ll introduce you to my Quarterly Cashflow Management spreadsheet that helps me optimize my entire system.

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  1. Pingback: Maximizing Cash Flow Part 4: How to See into the Future - Intelligent Advertiser

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