Ever heard someone casually talking about finances and think, “Hmmm…that doesn’t quite seem right?” Here’s a modern example: “That stock is at an all-time high. It can only go down from here. You’d be a fool to buy it now.” Check out Amazon’s stock price and press the “Max” button. Those “all time highs” in 2010 look like a decent place to buy in, don’t they? I hear this kind of “common sense” from locker room financial gurus all the time, and some financial misconceptions are much more frequently repeated than others.
The world of money can be confusing! It involves a combination of math, economics, government programs and laws, Microsoft Excel, Human Resources, Wall Street…it’s not everyone’s cup of tea. So today I thought I’d take a stab at correcting some of these common mistakes. Maybe you’ve heard them before—or maybe you believe them yourself. No worries. I hope I can convince you of some of the corrected versions. And as always, feel free to leave your comments, ask questions, or post some financial misconceptions that you’ve heard in your money travels.
Will a raise hurt me?
If you take a raise (or a benefit, or another form of income) that pushes you into the next tax bracket, you could actually lose money in the transaction. Your tax bill will increase so much that the raise will hurt you. You’ll take home less money.
Just on the surface alone, I hope your bull detectors are whirring to life. How could the government institute taxation systems whereby its citizens are hurt by increasing their income? This has to be one of the clearest financial misconceptions, right? Right?
Right! The US income tax system is graduated. That means that the first dollars you earn are taxed at a lower rate, while the last dollars you earn are taxed at a higher rate. My first $10,000 are taxed exactly the same as your first $10,000, and, in fact, the same as Tom Cruise’s. Hey Tom! But my last dollar is taxed significantly less than Tom’s last dollar. There is never a point where all of your income gets taxed at higher rates. Perhaps the best explanation is through example.
Andy’s income is $80,000, and Becky’s income is $85,000. It just so happens that there’s a differentiation in the 2018 tax rates at $82,500. This would worry people who believe Mistake #1, because it would mean that Becky would pay a higher rate than Andy, and might end up with less take-home pay despite having a higher salary.
In reality, here’s how it breaks down:
|Low End of Range||High End of Range||Andy’s |
If you do some math on those totals, you’ll notice that Andy takes home $66,460.50, while Becky takes home $70,310.50.
The “higher tax rate” only applies to the portion of money that falls into that particular range. In this case, that means that only the last $2500 of Becky’s salary is taxed at 24%. Her first $80,000 are taxed exactly the same as Andy’s $80,000.
Why is this tax mistake being made?
We already covered the idea of the graduated (or, some folks call it marginal) tax system. If you thought the system worked another way, then clearly that’s the issue here.
But another source of the erroneous thinking has to do with government programs, subsidies, and other income-based benefits that citizens receive. Let’s say you’re getting $5000 of benefits from the government. If you take a raise, the faulty logic is that your new income might surpass the requirements to receive that $5000 benefit. A $1000 raise might push you over the requirement ledge, you’ll lose the $5000 benefit, and you’ll end up $4000 down. But, just as with the original mistake, the assumptions behind this logic are flawed.
Benefits programs usually utilize “phase out” ramps, that slowly reduce your benefits as your income increases. For example, the Federal Child Tax credit (a $1000 benefit) for a married couple starts phasing out at $110,000, and it phases out at 5%. What does that mean?
First, let’s tackle the 5% part. Five parts per 100. That’s $50 per $1,000. Agreed?
Now, let’s combine that with the $110,000. When a couple’s combined income is $110,000 or under, they get the full Child Tax benefit of $1000. But when their combined income becomes $111,000 ($1,000 over the limit), they lose $50 of the benefit. $50 is 5% of $1000. The benefit for them is now only $950. So they got a $1000 raise (nice!) but lost $50 of Child Tax credit (shucks). And then they’ll have to pay $240 in federal tax on that $1,000. Maybe they’ll have to pay some state and local income tax as well…it’s usually a lot less than federal, so let’s say that’s another $50.
Gained $1000, paid $240 in Fed Tax, paid $50 in local tax, and lost $50 of benefit from the Child Tax credit. Let’s do some math…this couple is still up $660; not too bad! They certainly didn’t lose money by increasing their income.
“Get a BIG tax refund!”
Be extra conservative on your W-4 (the tax documents you fill out through your employer). That way, you’ll get a BIG tax refund at the end of the year.
Your goal should be to be as accurate with your W-4 as possible, so that your refund (or, in some cases, the amount you owe the government) is as close to zero as possible.**
When you get a BIG refund at the end of the year, it means that the government was holding onto a BIG amount of your money that it didn’t deserve. That alone is an issue. Why aren’t you (or an account you control) in possession of your money? The government certainly doesn’t pay you interest for the fact that you just loaned it a BIG amount of money. Whereas if you’d been holding onto that money, you could have earned interest through investments or even a simple savings account.
Letting Uncle Sam get an interest-free loan–while generous–is completely unneeded. Yet we all know scores of people who do this. That’s why this is one of the most widespread financial misconceptions.
Why is this mistake being made?
It’s purely psychological. We like things that feel good, and getting a BIG check feels really good! I completely agree that being paid a BIG check feels great. But this isn’t a lottery check, where you happened upon a big sum of money and received something that you didn’t really earn. Instead, this is like that jerk in high school who borrowed $80 and didn’t pay you back until after graduation. That doesn’t feel really good. It feels like you finally got repaid for an overdue debt, and that you got jerked around in the meantime. Don’t let Uncle Sam jerk you around. Try to be accurate on your W-4.
**There’s an exception here, and again it’s based on psychology rather than on pure dollars and cents. For some folks, being conservative on their W-4 (and thus lowering how much they take home each paycheck) helps them save money. When they get paid less, they spend less. They live more frugally. And when the BIG refund check comes, it gets deposited into their savings or retirement accounts, reaping the rewards of their frugal “saving.”
While these folks could have lived the same exact lifestyle and gotten their money when they actually deserved it (as part of their paycheck), I certainly understand how this tactic would end up saving people money. At the end of the day, putting that full refund into savings at the end of the year is certainly better than some sort of irresponsible spending. But it will never be as good as saving/investing the money on time, when you deserve it.
“Budgets are for other people”
“Budgeting only matters for people who are living near their means, when every dollar matters. I’m living pretty comfortably, so I don’t need to track my spending.”
Let me tell you something…budgets help you save. This is the sneakiest of the financial misconceptions.
If there’s anything I’ve learned in my 3 years of consistent budgeting, it’s that awareness of spending is the single best way to reduce spending. You might think you’re not that bad when it comes to consumer purchases, nights out at the bar, work lunches…but how do you know? If you aren’t measuring your spending, then you aren’t managing. You aren’t in full control. And therefore—at best—you’re spending precisely what you assume. At worst, you’re spending WAY more than you assume.
And that brings me full circle. If you institute a budget into your financial life, you’ll start to regain control of your spending. Your act of measurement will lead to management, which will lead to savings. And via the Ben Franklin Property, we know that those savings = earnings. It’s like you’re giving yourself a raise.
Would you ever let your boss tell you, “Listen, you’re getting paid enough, so, we’re not really going to track what we pay you. You might earn less than you expect this month, but you’ll still be comfortable.” Heck no!
So why would you ever tell yourself, “You’re comfortable, so you don’t need to track your spending. The amount you spend, the amount you save…these numbers aren’t relevant.” Don’t do that to yourself.
Saving is earning. Earning is saving. If you care about one, you should care about the other. Don’t let financial misconceptions throw you off balance!
Hope you enjoyed these first corrections to financial misconceptions. I’ll be back next week with a few more. Thanks for reading the Best Interest.
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If you want to get really interesting on marginal tax rates, take a look at the taxation of one’s Social Security Income. Based on the thresholds, 0%, 50% or 85% of those dollars are taxable. If a married couple’s provisional income is $44,000 their SSI is 50% taxable. If they earned $1 more, all of the Social Security income becomes 85% taxable and you truly end up paying more in taxes than total increased dollars earned.
Hi Craig! I appreciate your interest in the Best Interest, and really enjoy the reading adventure you sent me down. I ended up spending a lot of time looking at IRS Document 915. Are you familiar with that one? I’m looking at Example 3, starting on page 9. The couple in that example, Joe and Betty, have a provisional income of $45,500, and the SSI portion of that income ends up 62.75% taxable.
Looking at “Worksheet 1” of that document, I believe you can see the “phased ramps” that I refer to in this blog post. Based on this IRS document, Joe and Betty aren’t punished by taking that first dollar over $44K.
They earned $10K SSI out of their total income of $45.5K. Only the portion of their income over $44K (i.e. $1500) ended up being 85% taxable.
And just in case anyone else out there is reading this…note the difference between money being “taxable” vs. the rate at which it’s being taxed. In this case, only 62.5% of Joe and Betty’s SSI is taxable. The rate at which it is taxed would be determined by their marginal tax bracket, which I cover in the blog post. The rest of their SSI (the other 37.5%) is tax free! Nice!
Craig, what do you think? Does that make sense…or am I drastically misinformed?
Thanks again for reading!
Re: taxability of SSI benefits. My common sense just will not let me believe that “you truly end up paying more in taxes than total increased dollars earned.”
So the more I earn the more I lose? Earning more money costs me money? Can’t be…
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