What if there is a different way of thinking about money that you never previously considered?
Most people think of money in a one-dimensional fashion. Some of the phrases they use to describe it are take-home pay, pocket money, or spending money. What they are referring to in this singular dimension is after-tax or post-tax money.
By the very nature of our tax system, there are two other ways to think of money. These different ways are often written about and discussed, but I don’t think most people truly understand them.
I was speaking to a group of employees at a 401k plan recently, describing how to use the 401k as an effective way to save money for retirement.
I asked for questions, and the room lit up with questions—I love it when people are on the court! I noticed that many of the questions stemmed from the fact that few people understand this concept of the different types of money.
So here is what I asked the group: if you decide to buy a big-screen TV and it costs $800, how much did it cost you?
After some silence and then a few guesses, I explained that depending on your federal income tax bracket, you would have to earn $800 plus your tax bracket to buy the TV. So, for example, if you are in the 20% marginal tax bracket, you would have to earn $1,000 to buy the $800 TV.
Immediately, people in the room were clearly taken back by this notion. So, I wrote it out on the board:
Taxes at 20%: $1,000 x .20 = $200.00
Net Pay: $1,000.00 – $200.00 = $800.00
This is how ALL taxable income works. So, for example, if you earn money from employment OR you’re retired and earn income from a taxable pension or a taxable investment account like a money market, CD, or savings account, the dollar you earn is taxed before spending it.
So, if you’ve been saving money in a CD to buy something, you are taxed on the interest. The sad thing about taxable interest earned in banks these days is the interest rates are just barely above zero, and then, at the end of the year, you get a federal tax form 1099 with the small bit of interest you earned to add to your taxable income. So, on top of not earning much, you have to pay taxes on the meager amount of income.
With a paycheck, they take it right off the top in the form of paycheck withholdings, and with a CD, they take it next April when you file your tax return. So either way, they take it, and you have to earn more money than what you are actually spending on an after-tax basis.
So if after-tax or post-tax money is the one dimension that we think of money as, what is the other dimension? Before-tax, of course!
This is why money geeks like me get excited about the opportunity to set aside money on a before-tax basis: every dollar goes to work immediately. Virtually everything we buy is bought with after-tax dollars, except one of our BIGGEST purchases in our lifetime – our retirement.
This is exactly what you do when you set aside part of your paycheck or part of your savings into a company-sponsored 401k plan, an IRA or if you are self-employed in a solo 401k, a SEP, or a SIMPLE plan.
It’s one of the few places where $1.00 is $1.00 and not $0.80. The government is letting you hold onto the money that you owe them. So, you can put the money into your account for years, invest it, earn a return on it and then pay it to them later. Hopefully, it’s much later in life and when you’re possibly in a lower marginal tax bracket.
These accounts can accept deposits on a pre-tax basis, so every dollar goes to work without paying taxes. Said another way: every dollar you deposit before-tax reduces your tax bill at tax-filing time.
Paying fewer taxes today immediately improves your cash flow and gives you more money to spend on other things, like a new big-screen TV. Plus, all the money that goes into the pre-tax account earns cash for your future spending.
You’ll pay tax on these income payments later in life, but you can control that. You will set up a monthly withdrawal amount to be sent to you—preferably as a direct deposit to your checking account—and you’ll pay the taxes as you go, just like withholdings from your paycheck while working.
So someone in the 401k group said, “You mean to tell me I have to earn $1,000 to buy an $800 TV?” I said it’s actually worse because I didn’t include FICA in the calculation. But to keep things simple, yes, $1,000 to get $800.
“So everything we spend money on is in after-tax dollars?” she asked. I said, “well, not everything.”
P.S. There is a third dimension to money that I’ll discuss in my next blog post. It’s the best of the three, so stay tuned!