No statement has better summed up the emotional and practical struggles confronting average people attempting to build a better life for themselves and their families than a saying that has been attributed to a very, very successful investor, now one of the wealthiest men in the world with a fortune estimated at more than $2 billion: “The first $100,000 is a bitch.” Pardon the language, but speaking from my own personal experience, I unequivocally agree and can attest to that fact. Part of this is the result of the tax code. Part of it is the very nature of compounding – simple math tells you that a 10% return on $1,000,000 is $100,000; with that kind of money, such a return is near effortless versus a teacher who would struggle to scrape together $10,000 or $20,000. The third part is experience. Imagine the time, effort, and heartache you could save yourself if you could go back and speak to yourself at fifteen or sixteen years old, passing on knowledge about not just money, but life in general.
In this step-by-step, part of The Complete Beginner’s Guide to Saving Money, I’m going to give you some general outlines that will help you get started on the road to putting aside your first $100,000 in investment capital, free and clear. Of course, laws and customs vary by state, region, and country, so none of this constitutes investment, tax, or legal advice and you need to consult your appropriate professional to ensure that a particular strategy, structure or course of action is right for you. In the end, my hope is that it will make saving and investing just a little bit easier.
Know the Tax Code
Income of less than approximately $100,000 per annum is subject to payroll taxes, consisting of government programs such as social security and medicaid. This payroll tax of 15.3% is paid half by the employee and half by the employer (if you are self-employed, you are on the line for the full 15.3% on your own – that is, in addition to your regular income taxes, you are going to owe the Federal government $15,300 on that first $100,000 of income). The good news is that half of your payroll taxes are deductible from your income taxes, but the net effect is still that many American citizens pay far more than their stated income tax bracket would have them believe. As you get wealthier, the tax burden as a percentage of disposal income begins to decrease despite being higher in absolute dollars. In other words, if you make $800,000 and pay $300,000 in taxes, it’s not likely to hurt your standard of living but if you make $20,000 and pay $3,500 in taxes, it might mean you can’t keep the heat on during winter.
It is during this time in one’s life – when they are struggling to pay bills and still subject to payroll taxes – that it is most difficult to build wealth. Congress has provided several ways to get ahead in the tax code, notably through Roth IRA, Traditional IRA, and 401k plans. In the case of the latter two, money paid in for investments is tax-deductible at the time it is invested. For example, if you contribute $5,000 to a 401k and you’re in the 25% bracket, you won’t have to pay $1,250 in Federal income taxes on that money because, for the time being, as far as the government is concerned, it never existed. That means that right out of the gate, you have $1,250 working for you. If you were to take that money in your paycheck to attempt to pay your bills, you would only end up with $0.75 on the $1 due to the income tax bite.
Go After Free Money
Likewise, if you are going to be in debt (which is not exactly ideal), make sure you go for the low-cost, tax-deductible, long-term, fixed-rate kind. Personal credit card interest isn’t tax deductible. Let’s say you have a $15,000 balance and your cards are charging you 23% interest per annum. You are going to have to come up with nearly $3,500 per year just to cover the interest payments – that’s not even paying down the principal! That money is not deductible on your income taxes or for your payroll taxes, meaning that for most Americans earning less than $100,000 per year, you are going to have to make $5,200 pre-tax to cover your interest costs! That’s $200 per pay period if you are paid bi-weekly (26 times per year), or $433 if you are paid monthly. Think about that – $433 per month of your income just to service interest costs, without reducing the principal balance. For someone working 40 hours per week, 52 weeks per year, that’s $2.50 per hour just to maintain their debt load. That’s devastating to someone making $8 or $10 per hour. Now, talk about trying to not only pay down the debt, but put money aside for a better life and it gets to be daunting.
If your employer offers 401k matching, take advantage of it. In the above example, if you were to get dollar-for-dollar matching on the first, say, 5% of your contributions and you made $30,000 per year, you would get $1,500 in a bonus match deposited into your account. You already know that you saved $1,250 in taxes, so now, by simply putting $5,000 in your 401k, you have a total of $6,250 capital working for you – or $2,750 more than you would have had if you just took your regular paycheck, paid the taxes, and tried to money into a brokerage account! That’s nearly 79% more money at work for you!
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