Are You Looking at Spending the Wrong Way?

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A Different Approach to Spending Money

A Different Approach to Spending Money

By: Michael Dolen

We all know Benjamin Franklin’s famous quote, “A penny saved is a penny earned.” It’s actually a misquote, but that’s neither here nor there. The bottom line is that the spirit of this lesson is a cornerstone for good personal finance… or at least it used to be.

Contrary to popular belief, ol’ Ben’s quote no longer holds true. Why? Because back in his day, there was no IRS, no FICA tax, nor any of those other pesky things that shrink your paycheck. In the 18th century, a penny saved truly was a penny earned. However in the 21st century, a penny saved is much more than a penny earned.

Today: A Penny Saved = Two Pennies Earned?

Let’s say Joe is a self-employed handyman who lives in San Diego and his adjusted gross income is $55,000 per year. He happens to be unmarried, which means he is in the 25 percent federal tax bracket. He would owe up to this much in taxes:

  • 25 percent for federal income taxes. Income between $34,500 but not over $83,600 is taxed at 25 percent. The amounts below or above that bracket are of course taxed at different rates. With Joe’s income, that would mean $20.5k of his earnings are taxed at 25 percent ($55,000 minus $34,500 equals $20,500).
  • 15.3 percent for self-employment taxes. When you’re self-employed, you have to pay 100 percent of the Social Security and Medicare taxes yourself. If you work for someone else, the same 15.3 percent is paid but the difference is that 50 percent is paid by the employee and 50 percent by the employer.
  • 9.55 percent for state income tax. For the portion of Joe’s income above $46,766, he owes 9.55 percent to the State of California (in addition to the tax owed on the lower brackets).

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Now you can’t just add all three together and say Joe is paying 49.85 percent, because that would be ignoring the fact that his state tax is deductible for federal calculations, as well as half of his self-employed taxes. Not to mention, tax credits and the portion of his income that falls in the lower brackets is taxed at lower percentages (at least for the federal and state).

However, instead of making this demonstration messy and going through all of those calculations, let’s just agree on the fact that Joe is paying a lot of taxes, especially on the upper brackets of his income!

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How Joe (and All of Us) Should Think about Spending

When Joe goes to mall and whips out that platinum credit card to pay for a $100 coat, he should not think of it as costing $100. Instead, he needs to base the price on how much he has to earn (pre-tax) in order to have $100 to spend.

If all of his taxes combined equally, say 30 percent of his income, then here’s a more accurate way for Joe to look at how much his purchases cost him:

Step One: Subtract the 30 percent paid in taxes from his entire income (100 percent) and he is left with 70 percent for spending. In other words, 70 cents out of every $1 earned.

Step Two: Next, divide that $1 by 70 percent (0.70) and the result is $1.43.

Step Three: To find out how much he must earn to pay for a purchase, he can multiply the purchase price by 1.43. For example, that $100 coat would require $143 in earnings.

My Experience Using this Mindset

For the past two to three years, I have been using this approach. I can’t even begin to tell you how much smarter it has made me with spending. I totally disregard sticker prices and instead, recalculate the price of an item based on how much income I actually have to earn in order to pay for it. The result? I find myself spending much less! It really helps to put things into perspective and prioritize your financial life.

Here are some circumstances to demonstrate how this mindset can help:

  • A car costing $20,000 may sound reasonable to you. However when you look at it as costing $30,000 to $35,000 of your earnings ($20k times whatever your multiplier is), I bet there’s a good chance you will want the car that much less.
  • Credit card interest hasn’t been tax deductible for decades. So, of course, that means every $1 you pay in interest is more than $1 worth of your earnings. This mindset can serve as yet another motivating factor to pay down credit card debt more quickly and improve your credit.
  • You’re at the mall debating whether you should buy something. If you’re like how I used to be, you may try rationalizing the purchase by telling yourself something like “I make $20/hour and this item costs $100, so I can afford it since it’s only 5 hours of work.” But with the recalculation, you realize how many hours you really will have to work for it.

Now it’s time to get out a pen, paper and calculator and crunch away your own numbers to find out how much things are really costing you!

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This post was written by Michael Dolen, the founder of CreditCardForum. From how to increase your credit limit to a list of the top 10 credit cards, Michael blogs about every topic you can think of related to credit cards.

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