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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.
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.