Small Things Finance
I typically write about technology but I wanted to do a post on personal finance because it can change the trajectory of your life. Just like compound interest–what Albert Einstein once called the most powerful force in the universe–small things add up.
If you live in the United States, as I do, this need is even more pressing given the lack of any social safety net. Pensions no longer exist for most working Americans and have been replaced by self-directed 401k/403b/457 plans: in essence, every one is now a pension fund manager whether you realize it or not. Yes there is money in your later years from Social Security (though less than current recipients are getting) but nowhere close to enough to cover retirement let alone medical bills where Medicare falls short. Add onto this low rates of homeownership and records amount of student debt and it’s easy to see why the bedrocks of financial stability for previous generations are largely absent now.
For most of us, the only way to truly accumulate wealth is by setting up automatic savings, paying attention to investment fees, and minimizing taxes. These three decisions can be summed up as:
- how much to save
- where to invest
- minimize taxes
All three tasks require training which you will not find in the traditional educational system. But small things add up and the sooner you start creating a 3-pronged plan, the better.
How Much to Save?
Let’s start with the big question: how much to save? The first thing to assume is that you should save because Social Security–if it’s even around in a few decades–cannot be fully relied on to cover expenses.
Even if retirement is far off it’s important to create an Emergency Fund with 3-6 months of savings in case something comes up like medical bills, car bills, home repairs, or truly hating your job and needing the time to find something else.
Before anything else try to automate and put aside a portion of your paycheck–10% is a good amount to start with, especially if you are young and don’t have a family to consider–in a high-yield savings account.
Where to Invest?
Here’s the truth: no one knows what the market will do in the future. The best investing advice is to diversify your holdings and minimize fees. Pick a low-cost index fund with broad exposure, something like the Vanguard Total Stock Market Index Fund (VTSAX).
Also consider this: let’s say you truly are special and with enough effort can beat the market. How much effort does it take and how big is the end result? You’re probably talking hours a week of research, not to mention constantly thinking about the day-to-day performance of your holdings. If you look at the 168 hours in a week and consider how little time is available after subtracting sleep, work, and biological imperatives (food, bathroom, etc) is this how you want to spend all your free time and thoughts?
The US tax code is a mess, largely written by special interest groups representing the wealthiest individuals and industries. It follows the principle of “the Golden Rule” you learn about when studying accounting which is that “He who has the gold makes the rules.”
There are four main buckets of taxes to consider:
- Social Security
- Federal Income Taxes
- State Income Taxes
Together Social Security and Medicare take 15.3% off the top on the first $160,200 you make in 2023, or $24,511. This is known as FICA (Federal Insurance Contributions Act) and is visible on your W2 paycheck. If you are employed by a company they pay half this amount so the actual tax to an individual is 7.65% or $12,256.
Federal income taxes are “marginal” meaning lower income levels are taxed at lower amounts. You can think of it as buckets that are progressively filled. Even if you make $1,000,000 in annual income the first $22,000 is taxed at 10% if you are married and filing jointly. Then 12% for income between $22,001 and $89,450, and so on all the way up to 37% for income in excess of $693,750.
Finally there are state income taxes. Some states don’t have these and make the revenue up in other ways, usually in high property taxes. Other states have a flat tax. And still others have a progressive taxation system, such as California, where if you are married and file jointly income above $1,198,024 is taxed at 13.3%. That sounds quite high but consider that given the marginal tax rate if you make $120,000 the effective rate is only 4.5% which is far lower than many other states.
The simplest strategy to lower your taxes is to use tax-deferred savings accounts (401k/403b/457, IRA, HSA, 529, etc) to lower your taxable income now while you are working and income is higher. Then when you are retired and not working, your income will presumably be lower which means your marginal tax rate will also be lower and so you’ll save on lifetime taxes. If you are currently working in a state with high income taxes and plan to retire in a state with low or no income taxes, further savings can be found.
How you save your money is far easier to control than how much you can save. Choosing the optimum path early and sticking to it will lead to much greater wealth in the future. This concept is sometimes called the “Savings Pyramid.”
It’s important to note that if you have outstanding high interest debt charging 5%+, like credit cards, that should be the priority before putting savings aside. For other forms of debt like home loans, auto loans, and student loans the calculations require more nuance.
1) Emergency Fund: Aim to put aside 3-6 months of expenses in a safe location like a high-yield savings or money market account.
2) 401k/403b/457 up to company match: If your employer “matches” contributions, take it. This is free money. Often companies offer a 100% match on the first, say, 3% of contributions. If you make $50,000/year that means contributing $1,500 is matched by $1,500 from your employer. In other words, a $1,500 annual raise. Absolutely do this step first. Retirement contributions are also tax-deductible meaning they are deducted from your annual income and income taxes are deferred until funds are withdrawn in retirement, when most people are in a lower tax bracket.
3) Maximum Health Savings Account (HSA): If you have access to a high-deductible health plan, the HSA is a triple-tax advantaged savings device because it provides tax-deduction upfront, tax-deferred growth, and tax-free distributions for qualified medical expenses. The trick is to pay for medical expenses now out of pocket and contribute the maximum HSA contributions to grow tax-free. For 2023 the single contribution limit is $3,850 or $7,750 for a family.
4) Maximum Individual Retirement Accounts (IRA): An IRA is a self-directed individual retirement account. As of 2023, up to $6,500 can be invested each year and an additional $1,000 on top of that if you are over age 50 as a catch-up contribution. Traditional IRAs are tax-deductible and tax-deferred: contributions are not taxed upfront but instead when the money is withdrawn and the owner is (most likely) in a lower tax bracket. The Roth IRA is a post-tax retirement account where contributions are taxed up-front but future earnings are not. You need to be age 59.5+ to make withdrawals without a 10% penalty.
5) Maximum 401k/403b/457 Contributions: Once you have maxed out your IRA contributions, look at maximimzing your remaining 401k/403b/457 contributions which are tax-deductible. As of 2023 you can contribute up to $22,500 pre-tax and a total contribution (employee + employer contributions) of $66,000.
6) 529 Plans: A 529 is a tax-advantaged plan designed to encourage savings for future education costs. Any earnings are tax-free if used for qualified educational expenses such as college, graduate school, or up to $10,000 in private K-12 tuition. In addition, over 30 states offer a state income tax credit or deduction for contributions.
7) Brokerage Account: If you have remaining savings, an after-tax brokerage account is a good way to invest your savings. Aim to use a low-fee, broad-based index fund here and hold it for the long-term. There are no withdrawal requirements so you control when to remove any funds. And you’ll owe capital gains taxes when you sell which are far lower than ordinary income taxes.
It’s important to not become too lost in the details as many math/engineering focused minds tend to do. The point of managing your money well is to give you freedom and peace of mind.
For example, in most cases having a low-interest mortgage and investing other money makes more financial sense than paying early for a home. But if the subjective benefit of owning a home is quite high for you–as it is for many people–then by all means, don’t have a mortgage. The same reasoning goes for Roth vs Traditional IRA/401k accounts. For most people a traditional account that takes tax savings today will make more long-term financial sense, but a number of individuals find greater mental satisfaction in paying taxes up-front and knowing the money there is growing tax-free until forever and won’t require future deliberation around how to spend in retirement.
In short, some things make too much sense to pass up, such as maximizing any employer 401k matches as the top of your Savings Pyramid (that’s free money!), but others must balance financial and mental concerns.
The point of money is to allow you to control your life, not to have your money control you. Does it save some money to move to a low/no income-tax state? Sure. But what is the cost of upending your life if you have no other desire to do so and it would remove you from friends and family? If you just look at the numbers you’ll miss the bigger picture.
Educate yourself on the basics of personal finance, how to minimize taxes, and stay disciplined to the approach over the long term.