Triple Value of Income
My friends and family know I’m frugal but recently I was told by my ever-concerned mother that, “watching what you spend is fine but sometimes you just have to buy something nice for yourself without stressing out about it.” While I do agree with this to an extent, the comment made me think about why I never like spending money.
I’ve come to realize the part of my personality that makes me seek out the best deal for everything I buy is the same part that causes me to be uncomfortable every time I spend any money. The very act of spending the money means that I’m not getting the biggest bang for my buck. I’ll explain…
When I make a dollar at work, there are many things I can do with that dollar that will determine how valuable it actually is to me. If I decide to take that dollar out of my paycheck so that I can spend it, I am getting $0.80 of value out of that dollar because of my effective tax rate of 20%.
I worked hard for 40 hours this week but if I use my entire paycheck for spending I would be losing an entire day’s work worth of value from what I earned! I don’t know about you but I don’t want to work for free for a day a week just so I can buy things I don’t need.
If I instead put that dollar into a diversified stock portfolio, I am still initially losing that $0.20, because I am still paying income tax, but at least now it has the ability to recoup some of that lost value over time. Leaving that $0.80 invested for 10 years, earning the 7% average stock market real rate of return (i.e. after inflation), the dollar will grow to $1.57, which will provide me with $1.45 of value (assuming a 15% capital gains tax).
If I go a step further and contribute that dollar to my 401k or IRA, I am bypassing the income tax initially, therefore putting the full value of my dollar to work. Assuming I begin withdrawing from my retirement account in 30 years, the value of the dollar I put into the account will be $6.70 (again assuming an average 7% return, after inflation, and a 12% effective tax rate at withdrawal).
What if my employer offered a retirement match program? If I contribute a dollar and my employer matches me, I am initially getting a whopping $2 worth of value! Who wouldn’t love a 100% raise? Again assuming, I leave those two dollars invested for 30 years, I would eventually receive $13.39 in value from that single dollar!
Okay, getting double the value of my dollar is really exciting and investing that $2 and growing it to $13.39 by the time I am 60 is even more exciting but who says I have to spend that dollar when I turn 60? What if I leave that money invested and instead spend the interest/dividends I am earning on that money. That dollar that would have only been worth $0.80 had I spent it when I earned it is now providing me over $0.80 every two years (assuming a 3.5% yield)!
It may not seem like a big deal when we focus on the value of a single dollar, but if we expand what has been discussed to larger numbers, you can see how these ideas can really supercharge your FI savings. By maximizing the value of the dollars you earn, you can give yourself a huge raise without incurring any more responsibilities or working any additional hours.
Let’s assume you make $100,000 a year. If you spend everything you earn, your take-home value at the end of the year is roughly $80,000. If you instead put the majority of your income into your retirement, HSA, and investment accounts, you end up getting $254,242 of value out of that salary!
- Salary – $100,000
- Matched Retirement Contribution (5%) – $5,000 * $13.39 = $66,950
- Retirement Contribution Unmatched – $12,000 * $6.70 = $80,400
- HSA Contribution – $3,100 * $6.70 = $20,770
- Taxable Income – $79,900
- Taxes (16% Effective Rate) – $12,784
- Take Home – $61,068
- Invest – $42,116 * $1.45 = $61,068
- Spend – $25,000 * $0.80 = $20,000
Total = $66,950 + $80,400 + $20,770 + $61,068 + $20,000 = $249,188
By limiting your spending and maximizing your tax-advantaged allowances, you are getting over $249,188 in value out of your $100,000 salary. In order to get $249,188 of value out of a salary in which all proceeds are spent, you would need to make $348,514 a year ($348,514 minus 28.5% tax equals $249,188)!
I’ve created a calculator so that you can plug in your own numbers to see some figures that pertain to your situation. Head over to the Laboratory to experiment and see how much of a raise you can give yourself by being more intelligent with what you do with the money you earn.
I know my mom just wants me to be happy and treat myself every once in a while, but now I hope she can see that I am not depriving myself of enjoyment now just because I am a cheapskate. I am just putting off spending my dollar today so that dollar can grow into something that will provide me income and enjoyment for the rest of my life.