The Tax Gift of Frugality - Bro
Frugality is a gift to your future self. A small act at the present time can snowball into a huge benefit for future you. This is due to tax impacts, compounding, and added spending flexibility. It might not really seem like much now but with a bit of time these gifts add up to on heck of a holiday down the road. Of the benefits of frugality taxes are most often overlooked.
When most people think about their big three expenses typically housing, cars/transpiration, and food come to mind. The real number one expense for most people is taxes. Not only does Uncle Sam take 18% or more of your income but our dear Uncle also takes another pound of flesh with state taxes, sales tax, property tax, and various other sneaky fees. For every dollar you spend it takes significantly more than that dollar to make up for all of the other money that was taxed away.
Federal income tax is the largest hit you will take. Income tax ranges from 10% to 39.6% depending on how much you make in a year. The income tax levels are broken down into brackets. The system is marginal. The way I think about it being marginal is a series of buckets that flow into each other. If you are married the first bucket can hold $18,650 and any money that falls in it will be taxed at 10%. The next bucket can hold $57,250. Any money that falls in there is taxed at 15%. Between the two buckets you can earn $75,900. Each bucket gets larger and larger until you earn over $470,700 and any further money overflows and is taxed at 39.6%. The reason all of this math and buckets matter is because when you save a dollar in a tax sheltered account or choose not to work because you don't need to, those dollars are saved from your most “expensive” bucket. If you make $100,000 after deductions and decide to save $5,500 in your IRA, your savings is not your total tax rate (16.5%), but instead the 25% rate of your most expensive bucket. Your IRA contribution amounts to a savings of $1,375 in taxes. If you manage to save $1,000 by refinancing your mortgage and you use that savings to work a bit less than you are really saving yourself $1,333 in income you don’t need.
The next big hit is state tax. In Colorado where I live the state tax is 4.63%. Unlike federal income tax this is a flat tax across the board. If you go back to our example of the $1,000 saved by refinancing instead of saving yourself $1,333 you actual save $1,381. In some states there is no income tax but instead they tax property. In a lucky few states various taxes on business cover the costs of state government (Alaska and Wyoming come to mind).
A close second to state tax is the payroll tax. This is separate money that the government takes on top of your income tax for social security, medicare, and medicaid. For social security the cost to you is 6.2% and 6.2% to your employer. For my math I am going to ignore the employer match but keep in mind most economic arguments claim that if your employer was not taxed 6.2% you would get that money. For Medicare and Medicaid you are taxed at another 1.45% for a total payroll tax of 7.65%. If we were to add our payroll tax savings to our mortgage example we go from not needing $1,381 in income after state tax to $1,463 not needed in income.
If you were to buy a brand new car for $20,000 it will take you earning $31,887* to cover income tax to pay for it. At that point you are not even close to being done yet. Sales tax is still owed. Where I live that is 8%. With sales tax that brings our total income cost up to $33,487**. We are still not done yet. We need to add another $500 for registration for our new car putting us at $33,987 for what was supposed to be a $20,000 car. If we would have instead decided to skip the new car and just make our old car work we would have $33,987 of extra income we could gift to our future self (or not have to earn). This same math applies to small things as well. For that $5 coffee you would need to pay $8.37*** of your income. If instead you make that cup of coffee at home it would cost you $1 and that other $7.37 is a gift to your future self.
A dollar saved by frugality is not a dollar in our pocket but instead could be many extra dollars in our pocket. The next time you see a “screaming deal” on a new car think about uncle Sam’s cut.
Note: This is not a commentary on the amount of taxes we pay or where the money goes. I attempted to only state the numerical facts.
* $20,000 / (1 - .25 - .0463 - .0765) = $31,887
** $27,522 + ($20,000 * .08) = $33,487
*** $5 / (1 - .25 - .0463 - .0765) + $5*.08 = $8.37