One Dollar Allowance

Hopefully you read my previous post trying to dispel some incorrect understandings of how marginal tax brackets work. This will build off of that, including showing how the marginal tax brackets for annual income affect the “per paycheck” payroll withholdings your employer processes before paying you.

Let’s take another common misconception, the payroll tax withholding.

When you start a new job, your employer likely hands you a W-4 to fill out. This tells them how you want your federal taxes to be withheld from your paycheck. This depends on your filing status, the number of dependents you have, the way some of your personal activities throughout the year may affect any tax credits or deductions you’ll claim, etc. The W-4 is used to approximate your federal tax liability for the year, divided by the number of paychecks you’ll get in the year.

I’m going to look in my crystal ball and know that my federal tax liability for 2019 will be $13,000. I want to fill out my W-4 so that my employer knows to take out $500 of my paycheck every two weeks to pay the tax man on my behalf.

This is easier said than done, and most employers will allow an employee to adjust their withholdings throughout the year (I can do it for every paycheck if I needed or wanted to).

When you file your taxes in the winter/spring of the following year, this process analyzes your tax liability (what you owe based on deductions, credits, income, etc) and compares it to how much your employer paid on your behalf throughout the year. If your employer withheld too much, you get a refund. If your employer didn’t withhold enough, you have to pay. There are differing opinions on how to strategize this situation, but a general rule of thumb should be to match as well as possible your withholdings to your projected liability.

• If you get a refund, you’ve given Uncle Sam an interest free loan on your money for several months or the whole year. However, this can be a forced saving tool that people use who are scared they’d spend that money if they received it in their paycheck. Others see this as a cash windfall they receive in the spring and use it to splurge on a big purchase.
• If you owe money, sometimes there are fines for owing too much, and it can hurt to have to shell out a big sum of money at the beginning of every year, if you weren’t saving for it and didn’t expect it.

Where things get tricky, and people start to misunderstand, is if people get a bonus at work, or work some overtime, and get a higher paycheck than normal.

Payroll processors use a chart similar to the tax brackets, where they know your filing status and the number of exemptions you requested on your W-4, and use your income for that pay period to determine how much federal tax to withhold.

If every paycheck you get in the year is for working the same amount with the same salary, your withholding amount will not change and your taxes will be easy to follow and understand.

When it changes, payroll processors do not look at your yearly salary or previous pay periods. They only look at the dollar amount that you earned for that paycheck.

Let’s say you earn $2,000 per bi-weekly pay period in 2019. You file single with 1 exemption. Each exemption (withholding allowance) is worth a deduction of $161.50, so you can deduct $161.50 from your taxable wages for every paycheck for the purposes of reading the payroll withholding charts. (This dollar amount comes from the IRS, as part of their math for how withholdings are estimated to determine tax liability.) Now, you can say you “earned” $1,838.50.

More information on this can be found here, on pages 22 and 44 specifically.

From the chart, you owe (will have withheld) $174.70 plus 22% of the amount over $1,664, which is a balance of $174.50. Times this amount by 22% = $38 (rounded). This totals $213 deducted from your paycheck.

Let’s say that happens 24 out of the 26 paycheck you get this year, but in one, you get a $2,000 bonus, and in another you work $500 worth of overtime extra.

For the check with a bonus, your payroll processor knows you earned $4,000 that pay period, independent of what has happened the rest of the year. Using the same table, your tax withholding will be $553.32 plus 24% of what you earned above $3,385 (don’t forget to subtract your exemptions). That’s $109 more dollars. So you’ll have $662 deducted. That’s a big difference from your $178! Makes the bonus come with a tad bit of bad news, right?

The overtime paycheck works similarly, but because it’s only a little bit more money that paycheck relative to the norm, your tax withholding that check is $323.

Let’s add up your whole year.

24 paychecks of $2,000 income = $48,000 with ($213 times 24) $5,112 taxes withheld

One paycheck of $4,000 with $662 withheld.

One paycheck of $2,500 with $323 withheld.

$54,500 in earnings and $6,097 withheld.

Federal Income tax liability is 10% of $9,700, then 12% from $9,701 to $39,475, then 22% for the rest; this comes to $7,848. However, our system includes a standard deduction of $12,000. This means that you can take $12,000 off the top of your earnings and it won’t be taxed. We’re going to calculate as if you earned $42,500 for the year.

Your tax liability for the year is $5,208. With $6,097 withheld by your employer, this means you should expect an $889 refund!

A couple things were in play here. You claimed one exemption. You could’ve easily claimed a second exemption for some or all of the year to have less deducted from each paycheck to more closely match your eventual full year liability.

Secondly, those two paychecks where the payroll processor charged you extra tax, your paycheck was proportionally smaller, which means your refund at the end of the year was higher. You weren’t ACTUALLY taxed more for that bonus check, you simply had more withheld, a majority of which you’ll get back when you file in the winter/spring of the following year. The bonus check had an even more profound difference because the marginal bracket it fell into that period was the 24% bracket!

If your employer allows as many withholding/exemptions adjustments as you want, you can track your tax withholdings and projected liability changes throughout the year to strategize and minimize your potential difference between the two numbers.

In summary, your total annual income is the only thing that affects the tax liability when you file income taxes at the beginning of the following year. It does not matter if your paychecks were consistent, all over the place, front loaded, back loaded, or any other weird scenario that might happen with bonuses, overtime, raises, job changes, etc. Those variables do affect a single particular paycheck and how much cash you bring home in net that week, but the effects of that can be mitigated by shifting withholding amounts with your payroll processor and planning ahead by tracking your numbers.

Reminder, do not confuse payroll tax withholdings from your tax liability. Withholdings are an estimate, meant to match your projected liability. Filing your income tax at the end of the year simply remediates the difference between the two total amounts. If you had too much withheld, you get a refund. If you didn’t have enough withheld, you’ll owe the tax man.

HAPPY TAX SEASON!

Recent national media, Facebook, and personal interactions served as the catalyst for these posts on taxes. There is a lot of misinformation and misunderstanding of the way things work, which create opinions and divisiveness not necessarily based on fact.

First, let’s talk about tax brackets and the key word for the American tax system: marginal tax brackets.

In 2019 there are 7 tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Each of these brackets has varying dollar thresholds for the 4 filing statuses: single, married filing separately, married filing jointly, and head of household. Once you establish under what status you are filing, you know where each dollar you earn will fall in the brackets on the chart.

What I’ve heard many times before, and still see implications of misunderstanding in the media, are folks that think that the last, or highest, dollar you earn is what dictates what tax bracket you fall in. This is incorrect.

In 2019, single filers get taxed on 10% of their income up to $9,700. That means that the first dollars they earn are taxed at 10%, but the $9,701^st dollar they earn is taxed in the next bracket, or 12%. The 12% bracket goes to $39,475. Similarly, the $39,476^th dollar they earn will be taxed at 22%, and so on.

Individuals that say they do not want that raise, or to make more money, because it would put them in a higher tax bracket are sorely mistaken. Yes, the higher dollars they earn would be taxed more, but those dollars do not suddenly make all the lower amount of dollars be taxed at the high rate too. Those lower amounts stay in the marginal brackets they already were being placed in, based on the way the charts work.

Another single filer example (simplified for easier illustration). You make $80,000, which is the 22% bracket. Taxes for the year are figured as follows.

10% for $9,700 = $970

12% for $9,701 to $39,475 = $3,573

22% for $39,476 to $80,000 = $8,915

For a total tax liability of $970 + $3,573 + $8,915 = $13,458

If you make $80,000 and have to pay $13,458 in taxes, that is 16.8% of your income, not the 22% that the “tax bracket you fall in” might create the perception of.

Say you get a $10,000 raise to $90,000.

We know an $80,000 salary pays $13,458. Let’s add the taxes for the final $10,000.

$4,200 of that is still in the 22% tax brackets, so we can multiply = $924

$90,000 minus $84,200 = $5,800 in the 24% bracket = $1,392

So total taxes are $13,458 + $924 + $1,392 = $15,774.

That represents 17.5% of your income of $90,000 being paid to taxes, not the whole 24% bracket.

If we did not have marginal tax brackets and that raise really did bump all of your dollars up, or if it was calculated in a manner that many Americans think it is, then $90,000 times 24% = $21,600. It would look like your $10,000 raise caused you to pay $8,142 more taxes.

Good thing it doesn’t work that way!

We’re in a market downturn. These are expected, happen fairly frequently, and contain strategies to efficiently optimize the times they happen. One of those strategies is tax loss harvesting.

This year, we “benefit” even more from this strategy because the downturn is happening at the end of the year, at a time when savvy personal finance folks are thinking about all the varying ways they can reduce their tax liability for the closing year.

For the last decade, we’ve been in an uncommonly long and strong bull market, so many young people have no experience adapting to a struggling market and understanding ways to harness the red numbers.

Tax loss harvesting involves selling shares of a “losing” stock, fund, bond, etc and immediately purchasing a similar asset that’s “on sale” to maintain exposure to the market, hopefully buy at the low point, and prepare yourself for the eventual market upturn.

You cannot sell and buy the same stock or fund in this process because that would invoke the “wash sale” rule that disallows claiming capital losses. If you re-buy after thirty days, it’s no longer considered a wash sale.

The reason for utilizing this strategy is to be able to write off capital losses on taxes come April. This could offset earned income, other capital gains, dividends, passive income streams, etc. Paying fewer taxes is the goal, always, right?!

It could even have the double benefit of allowing you to get rid of a stock that doesn’t have a bright future in exchange for one that you think might be better.

Minor issue

One caveat to this strategy: you’ve now placed yourself in a lower dollar value cost basis in the new security you’ve purchased. When you choose to sell that, you’ll be subject to higher capital gains amounts. There are strategies to minimize that too. Tax gains harvesting is something people frequently employ. You do this in a year where your taxable income is lower (preferably below the $77,400 married filing jointly threshold for 2018) so that you can pay less or zero in capital gains taxes.

My circumstances

Personally, with Mrs. One Dollar Allowance quitting her job in 2019 to focus on child rearing and managing our rental properties, this year should be the highest tax liability we have in quite some time. Harvesting our losses this week will have a more substantial effect than it would in future down years, and will make the availability for tax gain harvesting in future up years more “profitable.”

Good luck to everyone in this tumultuous holiday week. Shutdowns and market losses don’t lend to great things on the news, but at least this strategy can add a silver lining to your end of the year tax decisions.

Student Loans

One of the things I have not had to be saddled with in my young adult life is student loan repayments for my wife or me. We both went to state schools, not the fancy private schools that really don’t typically provide much better (statistically) of an education anyway. My wife’s parents paid her tuition all 4 years, and her housing the first 2 years. She got a job to pay her housing otherwise.

I’ve had a lust for learning for as long as I can remember. I taught myself geometry at home while I was learning algebra at school so that I could compete better on the math team in middle school. I began taking accelerated classes in 3^rd grade, went to the “gifted” middle school program, was one of 30 kids in my county of 3000 freshmen to be accepted into the math and science program in high school, and went on to get a full academic scholarship to college. It covered tuition, housing, food, books, and a small stipend. I also applied for a couple small ad hoc scholarships that gave me some extra spending money those 4 years.

Side note – I finished 16^th in my class and opted to go to a state school with financial aid rather than a private or more prestigious school that I would have to pay for. My parents said 2 things early on: If you get a scholarship to college they’d buy me a car (hey, cheaper for them) and if I didn’t get a scholarship, I’d be going to the local state school. Massive student loans and private/out of state tuition weren’t an option. I am so indebted to my parents for many of the hard lines they drew, knowing what was best for their children despite us not being able to see it at the time.

Anyway, each step of my academic career prepared me for the next. I worked hard in elementary school to test into the middle school program. I really developed my passion for math in middle school and used it to get into the high school program. My success and test scores in high school propelled me to a college scholarship. My work ethic in college, despite the many factors that some adolescents fall victim to, had me graduate with honors and find an engineering job with the federal government – in the midst of the recession when the vast majority of all my graduating classmates couldn’t find work.

I was lucky to be born with a propensity to learn quickly and retain information that allowed me to succeed in school. However, I did not squander that gift and worked hard to use it efficiently and make smart decisions with my future in mind.

My parents instilled values in me that complemented my internal motivation to succeed. They created expectations that told me that anything less than success wouldn’t be tolerated. They even “dangled the carrot” of the new car that really catalyzed my drive (pun intended) to get that scholarship. These actions, both direct and indirect, in our household throughout childhood built the foundation for a solid academic career that got my finances and my net worth started in the positive direction once I became an adult.

Personal Finances

One of my earlier posts  focused on the ways my parents set my values for frugality, strategic decision making and spending, and saving. When I got money as a kid, I first saved it, then chose to carefully spend it when something was worth buying. When I got money from grandma for birthdays and Christmas, I put that money away for a rainy day rather than going and spending it all the next day. My wife and I still operate that way. Rather than looking at this “extra income” as a source of money to go buy something we don’t need, we simply add that money to our regular financial accounts to fund our next goal or debt payoff.

My parents led by example. When we traveled, we stayed at lower cost hotel chains, or with family and friends. We drove all of our vacations because flying was expensive. We brought our food and ate meals outside of restaurants where possible. Our day to day didn’t involve many restaurants. Feeding a family of 5 adds up quickly when you eat out. We didn’t have video games, a big screen TV, or the highest cable package, as socializing and playing outside is far more important to adolescent development than sitting behind a screen like many kids of the current generation.

As soon as I was old enough to understand, my dad began teaching me about investing. While in high school he helped me buy my first mutual fund (one that I still have, but I’m trying to find the right time to sell now that I realize the horror of high expense ratio funds!). When I went to college, I learned that he had been investing on behalf of my siblings and me for many years, and then gave us the money he’d invested as a gift to get us started in the real world.

Everything I saw, and continue to see, my parents do with any relation to finances or income and expenses is deliberate, and with the future in mind. This has translated to my own daily thinking. It became a habit, became natural. Since these thoughts and weighing of fiscal pros and cons have been part of me for as long as I can remember, it’s easy for me to analyze options on the fly and choose the best decision for my family in the moment. I don’t even have to try.

The one place that I would say I have deviated from my parents is my willingness to turn off the conservative thought process and attack my financial future with more risk and aggressiveness. However, growing up in a household of conservative money management gives me the past experience to draw from that keeps me grounded as I leverage more debt and make choices to expand my net worth as quickly as possible.

Stay tuned for more on the net worth conversation…

Compound Interest is the 8th wonder of the world

-Einstein

When I was a kid, I would walk into the bank to deposit something like $50 of soda selling money, and I would be so excited to see how my money had grown since the last time I had an account update.

There was no online banking. I had a bank-provided ledger book that the teller updated in ink pen for me every time I deposited money in my savings account. I wasn’t entirely sure how it worked in those early adolescent years, I just knew my money was supposed to grow by giving it to the bank.

I learned the details of the time value of money and compounding interest in middle school.

FV = PV x (1 + r)ⁿ where:

FV: Future Value

PV: Present Value

r: rate of return

n: number of periods

This is simply telling you what your money today will be worth in the future given the set of assumptions shown. For example, if I hadn’t saved a dollar since I started tracking my net worth in December 2010 and just wanted to know what that $30,000 is worth now (let’s say December 2018 for simplicity) at varying market conditions (let’s assume the market has averaged 8% gains in that time) then I would have:

FV = 30,000 x (1 + 0.08)⁸ = 55,528

A simple rule is that it takes about 10 years for your principal to double at 7% interest.

As many financial advisors will tell you, the power of compounding interest starts slow, but increases at exceedingly rapid levels the longer you extend the math.

After 20 years that $30,000 should be worth $139,828

After 30 years: $301,879

After 40 years: $651,735

Not bad that $30,000 of adolescent savings would be worth over $600,000 when I’m 63 years old.

Parents, teach your kids to save. Save early, save often. Many articles start hypothetical scenarios for saving for retirement at age 20. Why can’t you start at age 10 and add another decade of compounded interest to the math for retirement years?

The learning will compound as you teach your teenager positive financial habits, saving, frugality, and the power of math for watching your money grow.

Now lets say that I contribute $100 per month, or $1200 per year, to my retirement fund, starting back at the end of 2010.

The formula for that is:

FV = A [(〖(1 + r)〗^n -1)/r ] where A is the annual contribution.

FV = 1,200 [(〖(1 + 0.08)〗^8 -1)/0.08 ]= $12,763

If I had started doing that in December of 2010, I could add that money to the new worth of my original savings of $55k, totaling approximately $68,000.

Again, the value is from the many years of allowing this savings to compound.

After 20 years of $1,200 annual contributions I would have saved $54,914

After 30 years: $135,939

After 40 years: $310,867

If you add that money to the future value of my original savings, I’ve got just shy of a million dollars of net worth. We can all find $100 a month in our budget to put toward retirement, can’t we?

Further, if you can avoid/minimize lifestyle inflation as you get older and your earnings increase, you can save more than $100 a month in your 30s, 40s, and 50s to grow these example dollar amounts much larger.

How do you avoid lifestyle inflation?

• Every time you get a raise – be it cost of living for inflation or merit based – you should set aside some (or all!) of that extra money in your paycheck to pay yourself first in your retirement savings.

Mrs. OneDollarAllowance here – This is how I handled my early retirement savings. I thought the concept of putting money towards something so far away, while I was barely getting by with living expenses in college, was ridiculous. My parents said, “at least put in what gets matched.” So I did. Six months into my part-time job, I graduated college and was hired full time, with about a $10,000 raise. With all of that extra money and no extra expenses, I should have maxed out my retirement, but I was a dumb kid. I increased my retirement savings, but didn’t max it. It wasn’t until I met Mr. OneDollarAllowance that I was pushed to contribute to all retirement accounts fully.

• Don’t rush to go buy the next big gas guzzling SUV. Drive your cars longer and buy vehicles that are more fuel efficient and reliable at higher mileage levels.
• Don’t go buy that big dream house in your 20s. You don’t need to keep up with the Joneses. Remember that people don’t post the negative side of their lives on social media. If you compare your life and your belongings to the people you see online, you’ll do yourself and your finances a disservice.
• Curb your craft beer and your fancy restaurant tastes. These are good to treat yourself to every now and then to maintain your sanity, but eating out is the biggest thing I see my generation spend their money on, watching their paychecks disappear every two weeks.

There are countless examples of ways you can flex your frugality muscles, but I’ll leave those for a future post.

Let’s go back to the numbers for increasing retirement savings and see what happens. We’re going to save $100 a month for the first decade, $200 a month for the second decade, $300, then $400 for the last decade.

There are several takeaways from this chart.

• It’s surprisingly simple to amass wealth purely from discipline and deliberate, consistent saving.
• In 40 years, your money multiplies quickly compared to the principal you invested.
• The amount of time you invest is far more important than the amount of money you invest. Note that the money that had 40 years to grow nearly had triple the effect of the last decade, which was 4 times as much money, but only had 10 years to grow.
• The starting principal made up 20% of total money invested, but its value after 40 years is 55% of the total.

In summary, it’s never too late to start saving, and the worst thing you can do is continue putting it off until tomorrow. The earlier you put money away and let it grow, the more it is worth when it’s time to tap into those funds.

I remember having about $450 to my name at about age 10. That money is worth approximately $2,200 now, and should be worth about $22,000 when I’m in my 60s. Not bad for selling sodas out of a wagon for a couple summers and then just not spending that money.