Ascending the Pyramid of Financial Shit Togetherness: Step #2
If you haven’t read and acted upon Step 1, do that before reading this post. The first step is foundational for everything that follows and without a solid foundation, you will never gather your financial shit together to a sufficient degree.
Today we are talking turkey.
Greenbacks.
Cabbage.
Knowing how much you bring in and how much Uncle Sam is going to keep for himself is essential to mastering your personal finances.
Step #2. Learn how much money you make and how taxes work.
As promised at the end of Step 1, I’m going to share the single best way to make your monthly spending data as meaningful as possible: convert it to hours of your life. You will do this by employing Vicki Robin’s ingenious concept of calculating your Real Hourly Wage. Here is a template you can use to make this easy and I will walk through the three steps below:
Step #1. Calculate how much time you spend on work.
If your job disappeared tomorrow and you didn’t need another one to get by, how much total time would it free up? Sum up your best estimate for each of the following items:
Time spent in the morning getting ready for work. Compare your morning routine on the weekend to during the workweek and quantify how much more time you spend getting ready each workday.
Time spent commuting to/from work. Include travel time if your job requires it.
Time spent physically at work.
Time spent working at home on evenings and weekends, including reviewing/answering emails.
Time spent decompressing from work, if necessary. If you come home from work full of energy and immediately launch into your personal life, this is zero. But if you need some time to unwind at the end of each day, make sure you include it in the total.
Step #2. Calculate how much money you are spending to support your current job.
Make sure to include all of the following:
Commuting costs including gas, maintenance, parking fees, tolls, etc. Estimate what % of your total driving is due to work and multiply that % by your average spending in these categories.
Costuming costs including uniforms, work shirts/ties/suits, cosmetics, etc.
Additional food expenses that you wouldn’t have if you didn’t work. Of course this wouldn’t be zero if you didn’t work but if you eat lunch out every weekday, count at least a few extra bucks/meal vs. what it would cost to eat at home.
Other job-related expenses like out of pocket certifications/trainings, “optional” social events, etc.
Step #3. Subtract the total annual work related expenses from your net pay, then divide that amount by your total annual hours worked. This is your Real Hourly Wage.
Alright, now take a deep breath.
The point of this exercise isn’t to make you feel like shit about how little you actually earn per hour. The point is to give you a magic number that converts every single dollar you spend into cold, hard TIME.
Understanding your spending in terms of how much of your life you actually have to trade for a particular purchase makes the dollars and cents on your expense tracking worksheet come to life. Here is the expense tracking worksheet from step 1 with a column added that uses your Real Hourly Wage to convert the expenses to time.
As an example, let’s say you have a 30 mile commute to/from work, you spend $200/month on gas, and your Real Hourly Wage is $20. This means that it takes you an entire 10-hour workday to earn the funds to drive to and from work. So essentially you are spending one day/month earning enough money to pay for the privilege of driving 40 minutes to and from work every day.
Unlike money, time is a truly finite resource. Use your Real Hourly Wage to learn how much time you are trading for everything you buy.
Now it’s time to tackle the sexiest topic in the history of sexy topics: Taxes. Parents, please note the following content may not be suitable for young children.
OK, so maybe there are two or three things you could argue are sexier than taxes but there are many good reasons why you need to know how taxes work:
For starters, taxes are your single largest expense. You may not realize this fact because they are often automatically deducted from your paycheck (unless you are self-employed) but what you pay in taxes likely exceeds your mortgage/rent, monthly food bill, and transportation costs combined. If you had to physically write a check to pay your taxes every month, I guarantee you would care about how they are calculated.
It’s also important to understand how significant changes in pre-tax income, either increases or decreases, will translate to your actual take-home pay, and taxes are the primary factor in this equation.
Lastly, not to get ahead of ourselves, but it’s absolutely critical that you have a basic understanding of how our tax system works for Step #6 in our personal finance knowledge quest. If for no other reason than it’s required to plant your flag atop Mount Financial Shit-Togetherness, I need you to suffer through a few paragraphs on taxes.
I get that it’s going to be a struggle so as a reward I’ve sprinkled several fascinating/captivating/hilarious YouTube videos throughout this post. For instance, here is a video that beautifully juxtaposes humanity’s near limitless capacity for achievement with our near limitless capacity for making fools of ourselves:
One last point before we dive in: The lack of precision regarding some terms in this post will be enough to get your father’s accountant to slam his green eyeshade on the table in a fit of rage. This isn’t a guide to preparing for the CPA exam, it’s a primer on how the American tax system works in general.
There are a shitload of different types of taxes. We are going to cover the six largest:
Federal Income Tax
Payroll Tax aka “FICA”
State Income Tax (+city tax, if applicable)
Capital gains Tax
Sales Tax
Property Tax
The easiest way to keep all of these straight is to break them into three categories:
Tax rates that don’t vary with income.
Tax rates that do vary with income.
Tax rates that may or may not vary with income.
Taxes that don’t vary with income
Let’s start with a tax that you are probably already intimately familiar with: Sales Tax. Pretty much anytime you buy shit, sales tax is added to the sticker price to come up with the grand total. The rate varies from state to state – five states don’t have any sales tax and California has the highest rate = 7.25%.
As long as you continue to buy things, you will always pay this tax (assuming you don’t live in Alaska, Delaware, Montana, New Hampshire, or Oregon).
The other big tax that doesn’t vary with income is Property Tax. If you own a house, the city where you live will calculate the house’s taxable value every year and make you pay a % of that in property taxes. The taxable value typically slowly increases each year (except when it takes a nosedive immediately after you and your pregnant wife buy your first house right after college), and the property tax rate tends to remain relatively stable in a given city but varies widely from place to place.
People often completely overlook property taxes when using online mortgage calculators to figure out “how much more house they can afford”. If you are moving to a bigger house in a higher property tax area, both variables in the property tax equation (taxable value and property tax rate) increase!
The result is that you will be paying a shitload more in property taxes to go along with your new, higher mortgage payment. That doesn’t mean it’s the wrong decision but it does mean that you must do your homework so you’re not surprised when your monthly payment goes up by $700 instead of $400.
As long as you live in a house, you will pay this tax forever. Even when your mortgage is paid off, you’re still on the hook for property taxes.
Alright! We made it through the first category. Here is a hilarious old man who is shocked to learn just how old he is:
Taxes that do vary with income
Let’s start with the big dog, Federal Income Tax. There is a four step process that your accountant or your tax software follows to determine whether you get a Federal tax refund or if you have to cut Uncle Sam a check:
Step #1. Calculate taxable income
Your taxable income is your total income minus any deductions you can take. Assuming your goal is to minimize the amount of taxes you must pay, you want your taxable income to be as low as possible.
You have the choice to either take the standard deduction or itemize deductions. “Itemize deductions” is one of those tax terms that causes normal people to fall asleep with their eyes open when you use it in casual conversation.
The government lets you choose between two options:
#1. Take the “standard deduction” = $12,000 per taxpayer.
#2. “Itemize deductions” = Take the sum of a bunch of assorted deductions that vary based on your personal circumstances. For example, you can deduct charitable contributions, interest on student loans, and some of the interest on your mortgage.
Your accountant or tax software will sum all of your assorted deductions from #2 above and then compare the total to the standard deduction. If it’s bigger, you will itemize deductions. If it’s smaller, you will take the standard deduction.
A key point here is that if you end up taking the standard deduction, none of the itemized deductions matter in terms of reducing your taxes owed. A “tax-deductible” $1,000 donation to your favorite charity doesn’t reduce your tax bill by a single dollar if you take the standard deduction.
To be clear, you should still donate to charity, just don’t count on your donations to increase the size of your tax refund unless you are ponying up some serious dough (enough to get the sum of all your itemized deductions to exceed the standard deduction).
The 2018 tax bill significantly increased the standard deduction from $6,350 to $12,000 per taxpayer, which means many more people will be taking the standard deduction starting in 2018.
Step #2. Determine taxes owed based on tax brackets
We have a progressive income tax system; different portions of your income are taxed at different rates. To understand what this looks like for different levels of income, let me introduce you to two friends of mine: Eric the Electrician and Bonnie the Banker.
Eric did a three-year apprenticeship after high school and five years later got his Master Electrician license. He is unusually self-conscious about the size of his calves and insists that Pierce Brosnan was a superior Bond to Daniel Craig. Because of this last fact, he is single and he makes $80,000/year.
Bonnie majored in finance in college, got hired right out of school as an analyst for an investment bank in Chicago and worked her ass off over the last 10 years to become a Managing Director. She met her husband Mitch at a tabletop gaming convention and it was love at first sight when they locked eyes over a Catan board. They have three kids, Bonnie makes a cool million/year and Mitch stays home with the kids.
Here is how Eric’s income is taxed at the federal level:
His first $9,525 is taxed at 10%. The next $29,175 he earns is taxed at 12%. The last $41,300 he earns is taxed at 22%. These seem like random dollar amounts but they are actually really important – they are the “tax brackets” and every time your income exceeds one of the brackets, you pay a larger chunk of tax on the next dollar you earn.
Think of it like a series of progressively larger buckets that you are filling up with hot, sweaty cash. Once you fill up the first bucket with $9,525, the next dollar goes into the bucket labeled “$9,526 - $38,700”. Once that bucket it full, if you have more coin, it goes into an even larger bucket labeled “$38,701 - $82,500”. There are seven buckets in total.
Once all of your money is in the buckets, Uncle Sam comes and takes a portion from each one. He takes a small nibble from the first bucket, a slightly larger bite from the second, then his appetite gets going for bucket three, and so on until he is scarfing down more than 1/3 of what’s in the last bucket.
In total, Eric owes $13,540 in Federal Income tax, which is 17% of his income.
Here is how Bonnie’s income is taxed at the federal level:
Much different picture here because Bonnie is making that fat cheddar but another important difference is that because she is married, the tax brackets change. The married brackets are exactly twice the single brackets until you are making $300,000 solo or $600,000 as a couple. For couples making more than $600K, the federal rate tops out at 37% but the high income single taxpayer doesn’t hit that rate until he/she clears $500K.
After the dust settles, Bonnie and Mitch owe $309,379 in Federal Income tax, which is 31% of their total income. Because of our progressive income tax system, Bonnie and Mitch pay a larger total % of their income in taxes than Eric does.
Step #3. Reduce taxes owed by applying tax credits
Tax deductions that we talked about in Step #1 are nice. They reduce your taxable income and therefore reduce the amount of tax you have to pay. However, tax deductions get their asses viciously kicked by tax credits.
A refundable $1,000 tax credit is worth $1,000. A $1,000 tax deduction is worth at most $370 (if you are in the top federal tax bracket = 37%). For deductions, you only save the % that you would have paid in taxes. For credits, your tax bill is reduced on a dollar for dollar basis.
There are many different tax credits and one of the most common is the Child Tax Credit. For every dependent child you have who is under 18, you get a $2,000 tax credit. This starts to get phased out at high incomes, defined as $200K for single filers and $400K for couples.
Step #4. Compare taxes owed to taxes paid
After you’ve reduced your taxable income by applying deductions, calculated your taxes owed by using tax brackets, then reduced this number with tax credits thanks to your offspring, you end up with the final number of how much you should have paid in Federal Income Taxes. If you paid more tax than this during the year, you’ve got a refund coming your way. If you fell short, pony up the dough to the IRS.
A common refrain you will hear every Spring is along the lines of “My accountant is the best, we got almost $10,000 back last year”. Allow me to humbly offer a counterpoint: Your accountant is the worst because he/she let you give the government an interest free loan last year. 1/12 of that money could have been invested each month and grown 11% in 2017. So basically you paid your accountant a few hundred bucks to cost you $1,100.
Home stretch now! If you haven’t ever seen a Bad Lip Reading video, you’re welcome in advance:
Continuing with taxes that vary with income, what the hell is FICA aka “Payroll Tax”?
I’m glad you asked. Two things: Social Security tax + Medicare Tax.
Social Security tax is 6.2% of your first $128,400 in income. Your employer also pays 6.2% unless you are self-employed, in which case you pay the full 12.4%.
Medicare tax is 1.45% of your income, with no limit. Your employer also pays 1.45% unless you are self-employed, in which case you pay the full 2.9%. You also pay an additional 0.9% for income above $200K if you’re filing single and $250K if you’re married and filing jointly.
“Capital Gains” are essentially money you make on an investment. If you buy 100 shares of a stock for $20/share, it costs you $2,000. If that stock price increases to $25/share, your shares are now worth $2,500 on paper. If you choose to sell your shares, you have a $500 capital gain =$2,500 from the sale minus the $2,000 you originally paid. You pay taxes on the capital gain and how much you pay is based on whether it’s a Short-Term Capital Gain or a Long-Term Capital Gain:
If you made the original purchase less than one year ago, it’s a Short-Term Capital Gain. The gain is treated the same as regular income so the tax you pay depends on your tax bracket.
If you made the original purchase more than one year ago, it’s a Long-Term Capital Gain and it’s taxed at the following rates, based on your income:
As you may have noticed, the Long-Term Capital Gains rates are lower than the ordinary income tax rates at any level of income. If you could take 100% of your income as long-term capital gains, you would owe way less in taxes than if you got regular wages in a paycheck. This is part of the reason why very high income people sometimes have a lower overall tax rate than average income earners.
Now hold on one god-damned minute! Look at you! Plowing through paragraph after paragraph about itemized deductions and capital gains like a boss. Your reward is the best live news interview of all time:
Taxes that may or may not vary with income
State Income Tax varies from state to state. There are three different models:
No state income tax (9 states)
Flat state income tax (8 states including the best state): Every dollar of income is taxed at exactly the same rate. It ranges from 3.07% in Pennsylvania to 5.499% in North Carolina.
Progressive state income tax (33 states): Like the federal tax brackets, as your income increases, you pay a higher tax rate. This maxes out at 13.3% for Californians’ income above one million dollars/year.
If you are considering moving to another state, make sure you understand how/if your state income tax rate will change. Many online cost of living calculators completely fail to take this into account! Don’t forget about City Tax either – more and more cities are using this mechanism to fund local governments.
Pat yourself on the back, my friend. You not only made it through 2,619 words on taxes but if you did the exercises in this post and the previous one, you’ve officially left Level 1 in the Pyramid of Financial Shit Togetherness behind!
You may now consider your pecuniary poop moderately in a group. But you and I both know we still have work to do to make the summit.
Step #3 will not be a magnum opus like Steps 1 and 2 but it will focus on coming up with a game plan for deciphering and destroying your debt.