Why Saving Half Your Gross Income is Better and Easier Than Saving Half Your Net Income

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People frequently look to their accountant for sound financial advice. Good accountants are up to the task; other, not so much. Finding a good one is easy; they tell you what you don’t want to hear even if you threaten to leave.

Advice sought from accountants runs the gamut. Selling or buying a business requires in-depth analysis and most people trust their accountant’s judgment regarding this matter.

Then the bizarre requests come. Over the years I have been pulled to the side by clients wanting advice on how to raise their children, gambling problems, infidelity, and divorce issues. Some of the requests have a hint of tax built into them. Gambling problems are also tax problems. I’m never comfortable helping anyone decide if they should end their marriage. It’s not my place or at least shouldn’t be. And even if it was I want nothing to do with that kind of conflict.

My favorite requests are about personal finance, intelligent tax reduction and retirement. These are the moments when I can shine. It is also an area of massive risk. My mantra, oft repeated, is simple, yet rarely followed. First the client is in denial (which is a river in Egypt last I checked). Quickly the client moves to tell me my advice is impossible to follow and nobody does it. (Oh, yes they do.) Finally, the client starts to bargain her way into a deeper hole. They think they can change the rules and make it easier. Don’t they know I already thought of every twist and shortcut possible? Clients usually bargain themselves into a deeper hole without even knowing it.




Half for You and Half for Me

Clint Eastwood fans are well aware of the scam Blondie and Tuco had in the 1966 movie, The Good, The Bad and the Ugly. In the movie, Blondie, played by Eastwood, captures Tuco, a wanted bandit with a price on his head. Blondie turns Tuco in for the reward. As Tuco is about to be hanged Blondie shoots the rope from a safe distance and rescues Tuco only to do it again in another town.

After each escape, Blondie shares the gold with Tuco 50/50. (“Two for you and two for me.”) Of course things go south fast when Blondie decides it is time to end the business relationship. Every movie needs to keep the plot moving.

There is a lesson in finance in the business deal of sharing the spoils 50/50. It also happens to be the first part of my most common mantra: save half your gross income. I finish the mantra with: invest it in low-cost, broad-based index funds. It’s a simple concept and easy to remember. Save half or more each time income enters the household Cash Flow Statement before taxes.

As simple as the advice is, I always get pushback. As mentioned above, clients deny it is possible as if they are starting the stages of grief. Quick as a shot they get angry when I refuse to relent: save half. Then comes the bargaining and the reason for this post.




I Have a Better Idea

Imagine a client sitting across my desk dumbfounded by such a stupid suggestion. For easy calculation we will assume said client has exactly $100,000 of income (earned and/or rental or similar types of income) with exactly a 30% tax bracket. (My advice is straight-forward; taxes are never this simple.)

The “impossible” retort is quickly shot down by your favorite accountant as a straw man argument. I have plenty of clients earning half what you do and living within their means (probably saving half their income too). I also doubt you never had a day of your adult life where your income was less than it is now. So you have plenty of practice and examples of people (even an older version of you) who have or are doing it (living on half your current income).

The argument that bills are more now doesn’t work with me either. Things have not gone up that much in price! The problem is you have three SUV payments, a cottage, second home up north (it’s a Wisconsin thing), a Jet Ski and four-wheeler to make payments on and insure. That is the real reason why you are broke so stop arguing with me.

There is a simple solution: Start selling the excess baggage until your expenses allow you to save half your income. Pay off debt! You may not agree with me, but you know I’m right.

Time to get Serious

Quicker than a bolt of lightning you start the bargaining process. Before you waste your breath, I already know what you are going to ask and you are wrong. But why, you plead? Because saving half your gross income IS easier than saving half your net. Here’s why.

Take your $100,000 minus $30,000 taxes and you have $70,000 to spend. If you save half your gross, $50,000, you only have $20,000 left to live on! Not possible, you say.

If, on the other hand, you continue, I agree you should save half your net income ($35,000) it would be easier for you to make it really happen.

Wrong!

What happens when you save $50,000? Well, a good portion probably goes into retirement accounts. A husband and wife can plow $18,000 each into their 401(k) plan, assuming both are working, earn enough and the employers’ plans allows the maximum contribution allowed by the tax code. (Those 50 and older can add another $6,000 each to this total. In our example we will stick with young whipper-snappers.)

Each spouse can contribute another $5,500 into a traditional IRA. Added to the $36,000 contributed to the 401(k)s (not including the employer’s match), you now have $47,000 saved out of your 50% goal of saving half your gross income. $3,000 invested in a non-qualified account (non-retirement account) rounds out the $50,000 annual investment. If a Health Savings Account or other tax deferred/tax-free vehicle is available, all the better.

The above example is very simple and few will have the same exact situation. The basic example does allow us a quick look at the final results to the family budget. First, with all the money going into tax deferred accounts you probably now qualify for the Saver’s Credit and Earned Income Credit if you have kids. Add in any Child Tax Credits or other deductions and we don’t need to work any harder to reduce your tax liability because it is zero or close to it.

So how much money do you have available to spend now? Well, your taxes dropped $30,000 when you include credits. You have $50,000 invested, plus the employer’s match, and $50,000 available to spend. (FICA taxes will reduce numbers a bit, but we want to keep it simple so we can see why it is better to save half your gross income.)

Your bargaining to save less will leave you with less to spend in the end! Saving half your net, $35,000, means your taxable income is higher and you lose several powerful tax credits. Your tax liability will be lower, but probably not zero. You also lose the Earned Income Credit and Saver’s Credit, though the Child Tax Credit should still be allowed. If your taxes are lowered by $10,000 you are left with less overall money due to higher taxes!

$100,000 income – $20,000 tax – $35,000 saved/invested leaves $45,000 to spend, or,

if you’re are lucky and your taxes are reduced more without the full savings rate

$100,000 income – $10,000 tax – $35,000 saved/invested leaves $55,000 to spend

Just because you have more available to spend in some instances by saving half your net income you are really worse off. Your net worth is down $15,000 the first year alone without consideration for the employer’s match or investment gains. You bargained your way into working a decade or longer to make up the difference needed to get your nest egg large enough to fund retirement. Is it really worth years of additional required work just to have $5,000 more to waste on a gas-guzzling SUV today? I hope not. You wouldn’t be reading this blog if you really believed that.




Give Me the Facts

When I train a group of accountants I use the phrase “facts and circumstances” a lot. The IRS tax publications do too. Your facts and circumstances will change the outcome of our example. More moving parts usually means more opportunity to reduce tax and increase investments without harming disposable income.

It’s hard saving serious amounts of money. Unfortunately it is the only way to reach a reasonable retirement in a reasonable amount of time. Forty years is not a reasonable amount of time REQUIRED to work just to have enough liquid assets to retire with the same lifestyle as when you were working.

In The Good, The Bad and the Ugly things turned out well in the end. Blondie and Tuco teamed up again to cash in on the biggest payday ever. For folks familiar with the movie, Eastwood shares the spoils 50/50 one last time. He cuts the rope when he is safely out of Tuco’s reach. A funny scene to end a classic movie.

Fun movie! Entertaining. Serious lesson few grasped. Don’t make the same mistake. Half for you and half for me. The best part, you get to keep both halves.



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Keith Schroeder

24 Comments

  1. Dave on April 26, 2017 at 7:12 am

    Good stuff. I just realized this a couple of weeks ago, I wish it had been 10 years ago and maxed out my wife’s 403(b)

  2. Davis Barry on April 26, 2017 at 9:19 am

    Keith – with these types of examples if we assume both spouses work and make $50k for a total of $100k household income they wouldn’t both be able to sock away $18k to their respective 401(k)s, right? Lesser of $18k or 25% of gross pay, so assuming $50k/spouse they would only be able to contribute $12.5k each even if they had the means and desire to defer $18k. Or does this only apply to SARSEPs and not 401(k)s? Would love to hear your thoughts. Thanks.

    • Keith Schroeder on April 26, 2017 at 9:42 am

      You bring up a good point, Davis. I tried to reinforce in the post this is a thought experiment and not actual tax in practice.

      However, you CAN contribute up to 100% of your wage to a 401(k) up to the limits if your employer’s plan allows it. The tax code allows the first $18,000 to come from your paycheck and go straight to the 401(k). The 25% you mention applies to the employers match. Employers can deduct up to 25% of COMBINED wages for matching. (There can be issues if your wage exceeds $120,000. Talk to your employer’s HR department if you plan on maxing out your work retirement account and expect your wage/salary to exceed $120,000.)

      My example is accurate and works if the 401(k) you are in allows it. Many do. All you need to do is ask.

      Solo 401(k) plans with small businesses can match the full 25% because they are the only employee.

      SIMPLE IRAs for small business also allow a dollar for dollar deduction (no percentages) up to the limits ($12,500, or 15,500 for 50 and older).

      SEPs allow only 25% of wages for employees (20% for the self-employed). SARSEPSs established prior to 1997 follow 401(k) rules.

      You would be surprised how many readers of this blog, dedicated to maximizing retirement contributions and tax benefits, contribute a large percentage (50% and more) of their paycheck to their 401(k). They plan accordingly so they also maximize tax credits: Earned Income Credit, Saver’s Credit and others.

      Hope this helps, Davis.

      • Davis Barry on April 26, 2017 at 9:52 am

        Keith – Sounds like SEP IRAs are the only plans that are ‘restricted’ to a % of income, but as an employee it wouldn’t really matter since you can’t defer into the plan yourself. Thank you very much for the detailed response! I thoroughly enjoy your writing! Davis

  3. Anthony on April 26, 2017 at 9:47 am

    Should student loans be paid off before achieving this save rate? I have about 50k in loans left. I’ve paid off the highest interest rates ones but I still have several left between 4 and 5.8%.

    • Keith Schroeder on April 26, 2017 at 10:05 am

      I think the answer is to bifurcate your savings, Anthony. There are two thresholds I want you to reach: employer matching and student loan interest up to $2,500.

      Student loan interest is deductible up to $2,500 for most taxpayers. You want to pay enough of your student loans to capture as much of this deduction as possible.

      Likewise, you want to contribute a minimum of at least the employer’s matching level. If the employers matches the first 5%, then you need to contribute at least 5%.

      That said, I hate student loans. I have seen too many issues with clients over the years to encourage student debt. I might accept a mortgage on a rental or primary residence or even a modest business loan for an expanding business, but credit card and student loan debt is a problem with me. Credit cards are for capturing rewards only (pay them in full each month); student loans are a bridge to complete your degree. I want to see the student loans gone as fast as possible.

      Your facts and circumstances will play a major role in your decision process. Tax credits might make it a better choice to save more in the 401(k) than pay off the student loans faster. I suspect this will be the case at least partially. Run the numbers. Keeping the student loan a bit longer than necessary is okay if Uncle Sam is footing the bill in the form of tax savings and employer matching. Talk with your tax pro or, if you do your own taxes, pull out your tax return and run the numbers against last year’s return. Adjust for changes in 2017. You can very close the actual optimum sweet spot.

  4. Kristen on April 26, 2017 at 12:46 pm

    Great advice! I just found your site and I am a fellow Wisconsinite who just stumbled upon the FI community six months ago. I am kicking myself for all of my after-tax contributions instead of maxing out my 401(k).

  5. Steve RA on April 26, 2017 at 5:48 pm

    I fully understand the caveat of “your results may vary”, but hopefully I’m not the only one in this circumstance. With a single-earner household, getting tax-deferred contributions that help get under the cap for the Saver’s and EI Credit is difficult, right? At $100K income for one person, I can max out 401K and be down to $82K AGI. Add in my max $6750 for the HSA, and I’m at an AGI of $75,750, with “savings” right around 25% (if you include HSA in savings). To save 50% of gross, I need to put away another $25K in after-tax income, or $31,750 if you exclude HSA savings.

    How else can I reduce AGI without 2 earners to dump that 401k money into?

    • Keith Schroeder on April 26, 2017 at 5:55 pm

      Two income households have an advantage, Steve. A single person with a $100,000 will need a business or rental properties to achieve the same goals. That is the subject of a later and much longer post. There is always a what-if when writing about taxes. Each situation is different and I need to say it often so people don’t expect their situation to be identical. Sometimes it is hard to reach the same goal, other times not. Regardless, a single income household will need a different approach. Always “facts and circumstances”, Steve.

      • Davis on April 27, 2017 at 8:14 am

        Keith – would love to see a post about this when/if it makes sense for your blog!

  6. ConfusedMary on April 26, 2017 at 7:56 pm

    Am I missing something? The income limit on Saver’s credit is 60,000 for a couple. EITC is 51k. How does a couple qualify when they’re making 100k gross? Also how is that reducing their tax liability by 30k when the max on Saver’s is 2k?

    • Keith Schroeder on April 26, 2017 at 9:14 pm

      There are many ways to reduce taxes, Mary. $47,000 going into a 401(k) and $11,000 into a traditional IRA will reduce the income tax. A married couple with three or more children can make $53,505 before losing the EIC (without respect for retirement contributions), assuming unearned income doesn’t disallow the credit. Joint filers can earn up to $61,500 before losing the Savers Credit.

      The EIC is almost certainly out unless a business loss is on the return. However, the Daycare and Dependent Credit, Savers Credit and Child Tax Credit are in.

      I took the time to actually run the numbers through the tax software. (I can do it by hand but prefer letting the computer perform the rote calculations.) Here is what happens when the only income is two earners with exactly $50,000 each, three children ($5,000 of qualified daycare expense) and no other income; each max out their 401(k) at $18,000 and contribute $5,500 to a traditional IRA each:

      W-2s, Box 1 have a total of $64,000 minus the IRA contributions leaves an AGI of $53,000. The standard deduction is $12,600, exemptions $20,250. Taxable income is $20,150; tax: $2,099. The daycare credit is $1,000; Savers Credit: $400; Child Tax Credit: $699. The Additional Child Tax Credit is $2,301. If the taxpayer has no withholding they still get a $2,301 refund.

      Let’s change it up a bit. Assume only one child and $2,500 of daycare expense. We get the same $53,000 AGI. The Daycare Credit is $500; Savers Credit is still $400; and the Child Tax Credit is $1,000. This leaves a tax of $1,414 or a tax rate of just over 1.4%. That is what I meant in the post by taxes being zero or nearly so.

      I threw in the EIC because I knew someone would say, “What if I have a side gig business with a loss?” It is impossible to cover every contingency in an example. I tossed out several possible credits, but considered only the standard deduction. If example two in this comment included state taxes, mortgage interest, property taxes and charitable contributions itemizing may have played a role. The possibilities are endless. The point was to focus on the possibilities when you save a large part of your gross income. That part is much clearer. You are always better off with more money saved/invested and it doesn’t hurt as bad as you thought it would.

  7. Chad on April 27, 2017 at 6:54 am

    So I should switch from funding my Roth to a traditional ira?

    • Keith Schroeder on April 27, 2017 at 7:07 am

      That wasn’t the purpose of this thought experiment, Chad. What I didn’t touch on was the Roth ladder where you can supercharge your savings with tax-free growth, but you don’t get an upfront deduction. My example showed the value of deductions today. However, I would not do exactly what the example illustrates. I personally use a Roth, forgoing a current deduction for a much large tax-free income later. I fill my retirement account at my business with deductible contributions and the remainder goes into a Roth. Your facts and circumstances will determine the optimal course. For most people a Roth IRA is appropriate and recommended.

  8. Sam on April 27, 2017 at 4:49 pm

    Great point and I take it to heart. However, there is something fairly misleading: putting $50k into a 401k doesn’t mean you’ve saved $50k. Some portion of that must be put aside for paying taxes when you take a distribution from the 401k. So you really only have saved about $40k (depending on your future tax bracket).

    • Keith Schroeder on April 27, 2017 at 5:34 pm

      I don’t think it is misleading, Sam. As I said in reply to an earlier comment, a Roth might be better. This is not tax planning, but a tax concept you need to modify to your personal needs. By calling it misleading is like saying your comment was misleading because the investment will grow and the tax could be larger than actual original contribution due to that growth. I want you to focus on the concept and the possibilities as they apply to you. If you can shave a sliver for personal use then I made a difference. No misleading was intended.

      • sam on April 27, 2017 at 6:54 pm

        I guess I’d do the (very rough) math like this.

        Scenario 1 (save half of net): Save $35k in 401k/tIRAs, pay $20k in taxes (30% of AGI). Have $45k to spend. Effective savings of $28k (assuming tax bracket of 20% in retirement).

        Scenario 2 (save half of gross): Save $50k in 401k/tIRAs/HSA, pay $10k in taxes (assume lowered tax bracket to 20% due to lower AGI). Have $40k to spend. Effective savings of $40k (assuming tax bracket of 20% in retirement).

      • Isaac on April 28, 2017 at 9:11 pm

        Another reason it is not misleading is the Roth conversion ladder. Someone saving 50% of his or her income is likely to be a candidate for early retirement. There are scenarios where pre-tax contributions can be completely tax free if executed correctly and the $50k put into the 401k would be $50k saved.

  9. noreen on April 28, 2017 at 4:58 pm

    *sigh* If I could only talk my husband into opening a 403(b)… Time to call the tax guy and see if he can play with our numbers and back me up.

  10. Josh on April 30, 2017 at 9:29 pm

    A few notes to fill in the gaps:

    – FICA taxes will be around $7,500, reducing the final spendable income amount
    -AGI under $75,300 gives the 15% bracket couple 0% cap gains/dividend tax rate on taxable accounts

    $100,000 gross wage
    – $18,000 401k(1)
    – $18,000 401k(2)
    – $6,800 HSA (1,2)
    =$57,200 (MAGI – adjusted to show qualification for TIRA deduction)
    – $11,000 TIRA
    =$46,200 AGI
    -$7,500 FICA
    =$38,700 total income left for spending
    ($12,600 ded/$8,100 exemption = $18,000 taxable income)
    $1,800 Federal Taxes on income (1.8% tax rate)
    $36,900 total income after federal witholding
    +$2,000 savers credit (50% of the max MFJ $4,000)
    = $38,900 total spending at end of year
    IRS OWES YOU $200. Good job, you paid no taxes and sent the IRS a bill. ($7,500 in FICA is not really a tax since the money will provide SS and Medi benefits in old age)

  11. Chuck on May 1, 2017 at 1:50 pm

    How would this look like with a stay-at-home spouse? Are they allowed to open up a 401k/IRA trad/Roth IRA without an income (or putting more money into retirement then income earned).

  12. anthony on May 10, 2017 at 11:43 am

    My wife only works part time and is going to stay home to take care of the kids. Can I contribute 18k for her out of my salary (around 120k) , in addition to 18k for me ) if she doesn’t work?

    • Keith Schroeder on May 10, 2017 at 12:12 pm

      She has to have earned income to contribute to a 401(k) plan. She could do a spousal IRA, but that is limited to $5,500 or $6,500 if 50 or older. So, the short answer is no, BUT there is some retirement contribution allowed at a lower level.

  13. Christopher Hipskind on November 7, 2017 at 4:58 pm

    Thank you.. Great article

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