Saving money better than earning

by Stephen Butler

Ben Franklin was apparently a big fan of nudity and wrote about the value of what he called "air baths." He's more commonly known, however, for being one of the earliest champions of the personal growth movement spouting aphorisms about getting to bed early, eating apples, and pointing out that "a penny saved is a penny earned."

In fact, a dollar saved today is actually equivalent to almost two dollars earned in these days of hyper-taxation with even more taxation to come. When it comes to taxes, most of us fail to consider the extent to which it should impact so much of our decision-making.

For openers, we fail to appreciate the concept of marginal tax brackets. With the median family income in the $70,000-plus range, the average Californian is easily in a 35 percent tax bracket on the last few dollars of income when combining federal plus California marginal income taxes. If we are talking about job income, as opposed to retiree investment income like interest, then the marginal tax bracket is kicked up by another 10 percent because of Social Security and Medicare. Most workers (or retirees working part-time) who increase their income by $1,000 will be lucky to have much more than $550 of additional money to spend after total taxes of 45 percent on this last $1,000 of income.

Alan Greenspan, a latter-day Ben Franklin, points out that when an issue is complex, it is useful to take it to the extreme. "If deficits didn't matter, and tax cuts unmatched by spending cuts were good public policy, then why not eliminate all taxes? ... as we have seen in developing countries, unbridled government borrowing and spending produce hyperinflation and economic devastation."

If the current deficit leads to hyperinflation, then incomes grow but with dollars that become less valuable. These additional dollars just bump more of everyone's income into the level that is taxed at these high marginal rates. This "stealth tax" generates more money for the government without requiring any change in the tax rate. In one form or another, then, increased taxes will be hitting us like a freight train.

When it comes to financial decision-making, it is critical to understand how taxes impact everything. A retired couple whose lifestyle leaves them a little strapped for cash may be tempted to take more investment risk to generate that last $10,000 needed for homeowner association dues or other costs. It's important to understand that the additional gross income to meet that $10,000 need might have to be as high as $15,000 to $18,000 to have the necessary $10,000 left after paying taxes at the highest marginal rate on this money.

To generate that much more gross income, we may be having to take more risk --- or work more hours than we had anticipated at that part-time job. The temptation to invest in something that sounds "too good to be true" can be overwhelming in these situations.

It's also time to revisit mutual funds that invest in tax-free municipal bonds. At the moment, tax-free "muni's" are actually paying more than equivalent-maturity Treasury bills. Anyone in a high marginal tax bracket (retired couples with at least $70,000 of income including Social Security) should consider the fact that if the last few dollars of income can be tax-free, thanks to muni-bond interest. The current yield on investment-grade muni's is 5.3 percent and this payout is the equivalent of almost twice as much pre-tax income generated by conventional taxable bonds. Vanguard's Limited Term Tax-Exempt is a good start, but I also like their High-Yield Tax-Free fund paying 5.4 percent even though it carries more risk.

The retiree cited above would find that saving $10,000 somewhere in the budget would have been a more cost-effective approach than straining to generate an additional pre-tax $15,000 or more.

Again, the lesson here is that financial decision-making is all about taxes. Given the political climate, there is no practical way that the influence will get anything other than stronger. We will all further appreciate that the best things in life are free. Anyone for an "air bath?"

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