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Six Basic Personal Finance Facts People Should Know (but Constantly Get Wrong)
I get a pretty healthy number of questions from readers each week (usually by my personal Facebook page), many of which find their way into the weekly “reader mailbag” article.
While most of the questions are pretty interesting, I do find a lot of patterns in the questions that people ask me. I see a lot of people who struggle with a mountain of student loan and credit card debt in the early years of their professional lives for example, a situation that really hits home for me.
Another thing that I see regularly is questions from people confused by some aspect of personal finance because they have one fundamental fact or another about the situation completely wrong.
I’ll give you an example: perhaps once a month, I’ll get an angry message from someone telling me that I’m selling snake oil by telling people to earn a little more money in their spare time and that I need to tell people to keep their income low to avoid all of their money being taken by taxes.
Here are six key financial facts that people consistently get wrong. They use these facts as assumptions not only for questions that they ask me, but for how they behave in everyday life.
Fact #1: A Higher Tax Bracket Does Not Mean All of Your Income Is Taxed More
To get this discussion started, let’s look at the tax brackets for 2016 for a single person.
10% – $0 to $9,275
15% – $9,275 to $37,650
25% – $37,650 to $91,150
28% – $91,150 to $190,150
33% – $190,150 to $413,350
35% – $413,350 to $415,050
39.6% – $415,050+
Let’s say you’re a person making $37,500 a year. You’re just inside the 15% tax bracket. What happens if you make more?
The misconception is that if your income goes up to $38,000 a year, suddenly you have to pay 25% income tax on your whole salary. In other words, the thinking goes that if you make just $500 more in a year, your income tax goes from 15% of $37,500 – which is $5,625 – to 25% of $38,000 – which is $9,500. Under this incorrect thinking, earning $500 more would actually cost you $3,875. Obviously, earning a little more here would be a huge mistake.
But that’s not actually how taxes work.
In reality, when you make $37,500 a year, you pay 10% taxes on the first $9,275 of it (the first $9,275 of your income, in other words) and 15% taxes on the remaining $28,225 of it (since the rest falls into that $9,275 to $37,650 bracket). That adds up to a tax bill of $5,161.25.
If your income bumps up to $38,000 per year, the math doesn’t change much. You still pay 10% taxes on the first $9,275 of it. You pay 15% taxes on the amount between $9,275 and $37,650. You pay 25% taxes on the $350 that’s left over, which falls in the $37,650 to $91,150 bracket. This adds up to $5,271.25.
In other words, bumping up your income by $500 in this situation adds only $110 to your income taxes. You’re still keeping $390 more.
There is never a situation where increasing your income means you’ll have to give all of that increase to the government in taxes. That kind of idea comes either from people who struggle with math or people who are trying to mislead you.
Fact #2: When You Sell an Investment, You Only Owe Taxes on the Gains, Not on Everything
Let’s say you invest $100,000 out of your checking account into something – stocks, maybe. That investment does well, turning into $150,000. But then your uncle tells you to be very careful about taking that money out because you’ll owe lots of taxes on it.
Should you be worried? Maybe a little, but it’s not a doom and gloom scenario.
The misconception is that when you sell an investment, you’re going to owe taxes on all of the money that you receive. Let’s say this is an investment taxed at 15%, so under this misconception, when you sell that $150,000 investment, you’d owe $22,500 in taxes. That would eat up almost half of what you gained and, if that were the case, your uncle would be right. That would be painful.
But that’s not how it works.
The truth is, when you take money out of an investment that’s not in any sort of special account, you only pay taxes on the gains. You get your initial investment back without having to pay taxes on it. So, in this example, if you sell that $150,000 in stock, you’ll get your $100,000 back without taxes and only have to pay taxes on the $50,000. At 15% as described above, that’s only $7,500, not the incredibly painful $22,500 that your uncle might believe.
There are tax implications for selling investments, of course, but you simply don’t have to pay taxes on the amount that you originally invested unless something very unusual is going on.
Fact #3: Putting Money in Your 401(k) Doesn’t Mean Tax-Free Income, It Just Means You Pay the Taxes Later On
I have a friend of mine that acts like putting money into a 401(k) is some sort of secret ninja tax dodge. He’s very proud of the fact that every dollar that he puts into his 401(k) is a dollar of income that he doesn’t have to pay taxes on this year.
And he’s absolutely right. It’s true that money that you put into your 401(k) is money that you don’t have to pay taxes on this year. But the key word is this year.
Let’s look at those tax brackets again:
10% – $0 to $9,275
15% – $9,275 to $37,650
25% – $37,650 to $91,150
28% – $91,150 to $190,150
33% – $190,150 to $413,350
35% – $413,350 to $415,050
39.6% – $415,050+
Let’s say you make $40,000 a year. If you contribute nothing to your 401(k), you’ll pay $5,771.25 in taxes this year. But let’s say you contribute 10% of your salary to your 401(k). In that case, you’ll owe only $4,936.25 in taxes because you’ll only be paying taxes on the remaining $36,000. Your taxes actually go down by $835, meaning that the $4,000 you put away only actually costs you $3,165 in terms of your take-home pay. Sweet, huh?
But those taxes aren’t a freebie. When you get old and retire, you’ll start taking money out of that 401(k) and that will be taxed as normal income.
Let’s say you make $20,000 a year from your other retirement benefits when you’re old. That would add up to $2,536.25 in income taxes. However, let’s say you also withdrew $4,000 a year from your 401(k). That brings your income up to $24,000 a year and thus brings your taxes up to $3,136.25. That’s an extra $600 in taxes.
A 401(k) doesn’t mean tax free money. It just means you’ll be paying it later on in life when you take the money out. Hopefully, your tax rates are lower at that point (due to government changes or personal income changes), in which case the 401(k) will save you some tax money over the long haul, but that’s not a guarantee.
Fact #4: Renting Isn’t Just Throwing Money Away and Buying a House Won’t Make You Rich Due to ‘Equity’
One of the central tenets of the “American dream” is that, in order to establish yourself financially in the world, you need to buy a house. When you add into that the real estate bubble of the 2000s and the flood of reality shows and quickly-produced books that talked about getting rich off of buying a house and flipping it, you end up with many people under the strong belief that they have to buy a house in order to have any financial success.
Don’t get me wrong – a home can be a good investment in the right situation. It’s just not the right choice for every situation.
On the flip side of this is the impression that renting a house or an apartment amounts to just throwing money away. This implies that you’re not throwing money away in the process of buying and paying for a home – and most likely, you are.
Let’s compare the two.
When you rent a property, you have to pay rent on that property as well as renters insurance, which is fairly cheap. That’s money that’s lost to you.
On the other hand, when you buy a home, you have to pay the closing costs upon the initial purchase. After that, you have to pay your mortgage bill (most of which is interest), homeowners insurance (which is more expensive than renters insurance), property taxes, homeowners association fees, and maintenance costs for your home. All of that money vanishes – a total that’s usually far more than the cost of renting. In exchange for that, you get a small amount of equity in your home – whatever amount the value of your home goes up (assuming you’re in a decent housing market) and the amount of your mortgage principal that you’re actually paying off each month.
It is absolutely not cut and dried as to which situation is better. It varies quite a lot, actually, as there are many specific situations where renting makes more financial sense and many specific situations where buying a home makes more sense.
How do you figure out which is right for you? In general, the time to buy a home is when you’re financially secure enough that you can’t easily lose the home due to a normal unexpected event or two.
Do you have a healthy job with some money in the bank? That’s when you should consider home ownership. If you take it on without a stable job or without significant savings and something goes wrong, not only do you lose any equity you may have gained, your credit is also shot for a very long time.
Fact #5: Having a Big Tax Return Costs You Money
One of my oldest friends posts on Facebook every year about how big his tax return is going to be. He actually turns it into multiple posts, where he talks about filing, waiting for the return, getting the return, and then using it for something or another. Getting a $3,000 return seems to be one of the high points of his year.
I don’t have the heart to tell him that he’s basically getting ripped off.
Every dollar of that tax return is a dollar that he paid in during the previous 12 months (or so). That’s because a tax return is just your money being sent back to you – it’s the extra taxes you had taken out of your paycheck during the year.
Let’s say my friend has, say, $100 taken out of each of his weekly paychecks during the year. That adds up to $5,200. His actual taxes at the end of the year add up to $2,200. Thus, he receives a $3,000 refund because he paid in $3,000 too much throughout the year.
Now, let’s look at a different plan. Let’s say my friend has, say, $45 taken out of his weekly paycheck all throughout the year. That adds up to $2,340. His paycheck each week is now $55 bigger. Since his actual taxes at the end of the year are $2,200, he’d now receive a $140 refund.
Why is that second scenario better? Let’s assume my friend is putting money on his credit card in order to make ends meet. That $55 could prevent that kind of credit card use, saving him more money by avoiding credit card interest. If he’s more financially responsible, he could save or invest that money himself. Even putting it in a savings account earns him 1% interest on that money so that he has more to spend next April. He could also do something like put it in a Roth IRA for retirement so that it earns a much higher return (7-8% on average).
There’s another big factor, too: in that second scenario, he has flexibility with that extra money throughout the year. If he puts it in his savings account and then, in November, his car breaks down, he can just pay for it in cash. It’s an emergency fund. On the other hand, he might use it to fund a Roth IRA and have a nice chunk of change building toward retirement before his tax return would ever come in.
The only advantage that a tax return has is that it serves as a zero-interest savings account for people without the personal willpower to save. That can be important to some, I suppose, but if you’re using a tax return effectively as a savings account, that doesn’t mean that the government is offering a great savings system. It means that you’re greatly lacking in terms of personal willpower, and you’re paying for that by losing out on the potential returns and flexibility you could get by saving that money yourself.
Fact #6: If You’re Unhappy, Having That Thing You Want Most Won’t Make You Happy
Over and over again, I’ll hear from readers who basically sound completely miserable in their day to day lives. They’re working at a job that they hate. They’re unhappy in their personal lives, too. They basically dread getting out of bed in the morning.
I hesitate to use these kinds of questions very often in the reader mailbag as I really have no interest in turning that article into a big “downer.” But the questions still roll in.
The questions that they share usually involve figuring out how to achieve some goal in their life. They’ve decided that some new thing – maybe a new car or a new house – will inject joy into their lives and turn the whole thing around.
“My life is miserable, but I really hate my commute. I am thinking of buying a luxury car to make things better and that will spread out through my life. Help me figure out how to do it.”
That’s a message I get pretty frequently. It’s never written quite that bluntly, but that’s what the idea comes down to. Their life is making them miserable, but they’ve decided that a new laptop or a new car or a new house will fix everything.
Getting that thing you’re fixated on, whether it’s a car or a house or a laptop or whatever it might be, will bring you a burst of joy, but that burst is fleeting. Soon, your life will return to the same routine. You’ll still be commuting to the same place. You’ll still be coming home to the same people. You’ll still have the same habits and life routines.
Buying something big and new won’t change any of that.
There are two big truths that run through these questions. First, how you spend your time has a lot more to do with your happiness than what things you own.
You can be incredibly happy and fulfilled in a rundown shack. You can be incredibly unhappy and miserable in a mansion. The question is whether you spend your time around people that you care about and enjoy their company (and people who care about you and enjoy your company), whether you have hobbies and leisure activities that leave you feeling fulfilled, and whether you allow the challenging areas of your life – and everyone has them – to overshadow everything else.
Second, whether or not you choose to be happy is also a vital factor in your own happiness.
What do you choose to think about when reflecting on life? Do you see the negatives in the things around you or the positives? Do you see a miserable commute, or do you see an hour where you can listen to NPR or an audiobook or some music and just chill out and learn something new or bob your head to the music? Do you see a miserable job with miserable people or do you see a great opportunity to earn more money than the vast majority of people in the world will ever see in their lives while all you have to do is sit in an office?
Naturally, there is a component of mental health in here. Anyone who has persistent negative feelings about large swaths of their life should at least talk to a mental health professional to figure out if there is a biochemical problem that is causing such feelings.
In the end, though, you choose your own life. In large part, you get to decide how happy you are with it. If you’re unhappy, buying something new won’t make you happy.
Quite often, the “facts” that people tout when it comes to personal finance aren’t quite “facts” at all. Sometimes, they’re just opinions stated with authority. At other times, they’re based on incorrect information or assumptions.
In either case, it’s always worth your time to sit down and think about why you’re making a particular personal finance choice. Why exactly is it that you’re wanting a big tax return? Where do you think the money goes if you get a smaller return instead, and why would a big return be better than that?
There should be a real reason for every dollar you spend and every hour that you spend, too. When you dig down and understand that reason, and then try to spend those dollars and hours in a positive way in your life, you’ll always end up in a better place.
Good luck finding the truth!