Are your kids around the house for the holidays? What a great time for sharing some financial wisdom while you have them as a captive audience. Who needs HDTV's, IPOD's or laptops when making this "Advice for Kids" column one of your "favorites" or "bookmarks" is as handy as the nearest pair of scissors? Clip it out and use a few magnets to slap it on the refrigerator door. The kids can check it out every time they go for more food. There are times when print media has no substitute.
A young person curious about how the world works financially should be asking:
1) How am I being taxed, and how does taxation affect spending or job decisions? 2) Why is buying a home or condominium such a good idea? 3) Why should I be depositing as much as possible into a tax-deferred retirement plan? 4) What simple investment advice should I apply to these deposits? 5) How do I make sure that I always have adequate health insurance coverage regardless of my job or school situation? And finally 6.) How do I develop street-smart habits when it comes to saving money?
First, you need to understand how taxes work. The average single young worker in California makes enough so that the last few dollars of income are taxed at least 25 percent. People make the mistake of taking total taxes paid and dividing by total income to estimate their "tax bracket." It may be that you pay as low as 10 or 15 percent of your total income in taxes. For most decisions, this percentage is meaningless.
Why? Because most financial decisions bump taxable income up a little or down a little. We take a new job, or stay put for a $200 per month raise. A raise, by definition, is the last few dollars of our income. It will be taxed at the highest level of taxes we are charged. If you create a tax table that combines Federal and state income taxes with Social Security and Medicare taxes, it will show that, for a single person, the actual dollars in earnings that fall between $26,000 and $36,000 are taxed at 42 percent. Any dollars over $36,000 are taxed at over 45 percent, and it just gets worse after that. This explains why, when we receive a raise, our "take-home pay" rises by far less than what we understood to be our gross increase in income. On the flip side, if your income drops because you cut back on work hours to go back to school, you may not be giving up that much spendable take-home pay, because those extra last dollars were taxed so highly anyway.
When we contribute to 401(k)s or IRAs, the money comes off the top and taxes are paid on what's left. We remove from taxable income the last few dollars that would have been taxed at the highest possible rate. When we make house payments instead of rent payments, we reduce income for tax-calculation purposes because mortgage interest and property taxes are tax-deductible. Rent is not. Whenever we say that something is "tax-deductible," it means that we can use the expense to reduce our taxable income, and any reduction is happening to those last few dollars that are taxed at the highest applicable rate.
Owning a home creates tremendous tax benefits and financial leverage. In a simple example, the down payment of $20,000 on a $100,000 condominium buys an asset that could double in value over 10 years if it appreciates at a rate of 7 percent per year. Ten years later, you sell the condo for $200,000 and pay back the $80,000 mortgage loan. You can keep the entire $100,000 profit you just made on your $20,000 down payment. Don't laugh about the $100,000 example. They are starting to pop up in Northern California already. A young first-time homebuyer has not been hit with slumping values of an existing home. Their buying opportunity has never been better.
Meanwhile, if you can afford $1,000 per month in rent, you can now afford $1,500 in house payments, because $500 of that $1,500 will be paid with money you are otherwise paying in taxes. In this example, a couple that pays $18,000 a year in house payments is saving at least $6,000 in income taxes. In other words, the government is effectively paying $6,000 of your annual house payment.
While you're saving for that house, you should be maxing out contributions to your employer's retirement plan, even though retirement is decades away. Figure it this way: $600 per month at 10 percent builds to $85,000 in about eight years or about as much time as you have spent in high school and college. A $600 contribution will cost most people about $400 in take-home pay, because $200 of the $600 is money that otherwise would have disappeared in taxes. Consider living at home so you can afford to contribute the $16,500 annual maximum. Meanwhile, it doesn't matter how you invest the money. Spread it out over all the mutual funds investing in stocks, and learn which types do well under different portions of the economic cycle. Bear in mind that if you head back to school, there's nothing wrong with tapping your 401(k) money to help fund a goal that has financial value.
When it comes to health insurance, moving from job to job and/or back to school leaves you dangerously exposed to the possibility of no coverage. The trick is to get a cheap, high-deductible policy. We can all somehow manage to round up $2,000 to pay medical bills, but $50,000 to $500,000 for a real serious illness or disease would wipe us, or our parents, completely out. Go to www.ehealthinsurance.com for help. These policies cost about $50 to $75 per month, and some parents would be wise to set up premiums for kids that are automatically deducted from parents' checking accounts.
Learn how to live frugally. Saving $10 per day by not buying coffee, bottled water, CD's and other complete money-wasters adds up to $3,650 "take-home pay" after-tax dollars per year. This allows us to afford about a $5,000 pre-tax 401(k) contribution. Save large! Get with the program. Who knows what you'll be doing ten years from now, but having $100,000 in a retirement plan can certainly widen your options. The harder you save, the luckier you'll get.