The following is a guest post by FS reader, Jamin Eberhart. He received his MBA, worked in biotech and now consults for biotech companies. He is extremely focused on building his freedom fund, and struggles just like me to find the right balance between living it up and being fiscally responsible.
The news media is always talking about how the top three costs for households are:
- Housing (rent or mortgage)
- Car (loan payments and interest)
- Education or Child Care (student loans or child schooling)
The truth is, they are wrong. Taxes are by far and away the largest cost that most households face. “Why is this important?” you might ask. “Aren’t taxes unavoidable?” you lament. The short answer, like many things in life, is yes and no. Will you be able to avoid paying taxes altogether? No. Can you take steps to lessen your tax bite and chip away at the single greatest expense you have? Yes! The how is for a later post. For now, let’s focus on step one… recognizing that you have a tax problem.
Let’s do some quick math. For simplicity, we will assume that our happy couple makes a combined income of $100,000 per year in the United States (married, filing jointly). Here are some of the immediate payroll taxes they face:
Note that I did not include some biggies like state income tax, property tax, and sales tax since at this income level, most if not all of those taxes can be written off against federal tax withholdings within limits. Already our lucky couple is paying nearly one third of their money to the government before having a chance to do anything productive with it for themselves. And yes, that employee funded amount for social security, medicare, and medicaid counts since that is a very real, direct salary cost to employers which could otherwise be paid to their staff.
Unfortunately, this tax chart isn’t even close to the full picture. All of those “little” taxes add up. State tax. City tax. Property tax. Gasoline tax. Alcohol tax. Airport tax. Cigarette tax. Estate tax. Public utilities tax. Telephone tax. Vehicle registration tax. The list goes on and on and the net effect can easily add another 10% in total taxes. Since I don’t have the time or inclination to write up an exacting review of the total US tax burden, I am grateful that author Jeremy Sands has already done so with his paper, The Real US Tax Burden.
The key takeaway is this: the average American household earns ~$53,600 per year and pays $24,600 in all taxes combined for a … drumroll please… 54% effective tax rate. How does it get that high? A bunch of different taxes add up quickly. For example, in California state income tax is about 8.5%, CA sales tax can be as high as 10% (in San Francisco it’s 8.75%), FICA is 6.2%, property tax is 1.12%, etc. If your household makes more than $53.6k per year guess what… it just keeps getting worse and worse.
LET US PAUSE AND BREATHE FOR A MINUTE
Another way to think about this astounding figure is based on what this average household needs to earn in order to buy anything from a bottle of shampoo to that lovely new car. For the average person, they need to earn double what the price tag reflects to actually complete the purchase. That morning latte at Starbucks, that’s not $4 but rather $8 of earnings down the drain. That new $35,000 luxury sedan? That will be $70,000+, not even factoring in interest and maintenance costs. Sobering, yet extremely important to recognize if you want motivation to curb spending.
Yet another way to think about this is that all forms of government in the US (federal, state, county, city/local) confiscate over half of the average household’s income every year, and yet they still cannot balance the national budget and always need more money. How much is enough when half of the productive effort of the nation is squandered just to keep up with the government’s reckless, ever expanding spending?
And to be clear, this is a discussion that neither the Democrats nor the Republicans want you to think about. None of them want you to think about your true total tax burden because they don’t want you to violently protest to their power when you learn the truth. This is why the presidential debates always spout figures based only on the federal income tax rate versus your total tax rate… you know, the one which actually matters the most to you.
All this is from a country which was intended by its founding fathers to never impose a federal tax on its citizens and managed to thrive for 137 years without a federal income tax (the 16th amendment to the US Constitution was passed in 1913 which allowed for the previously unconstitutional act of collecting federal income tax).
SO HOW CAN WE REDUCE OUR TAX LIABILITY?
To be clear, I highly recommend that you pay whatever taxes which are legally required of you. Don’t be foolish and evade taxes, it isn’t worth it. That being said, however, there are a number of completely legal ways to reduce your tax burden:
- Max out anything that allows you to defer taxes. 401k’s. 403(b)’s. Traditional/Roth IRA’s. SEP IRA’s. This is the #1 option open to most employees who don’t own their own business.
- Start your own business. You’d be amazed at how many personal expenses can be legitimately paid for out of your business’ account (thus saving you from paying taxes on your income first, and then paying for the expense)
- Buy less stuff. Governments have a hard time taxing money which is just sitting there earning interest, hence they tend to tax events and transactions (your monthly paycheck, dividend payments, store transactions, utility payments, …). The less you buy, the less they can take out of every transaction and the more that you can keep for a rainy day.
- Go a bit Galt.
- Become an awesome employee at an awesome company that has 401k match and profit sharing, AND become a freelancer so you can potentially put away over $100,000 tax free.
ONE LAST EXPENSE TO THINK OF (Sam addition)
Although this article makes a claim that taxes are our largest ongoing expense, there could be one more expense that’s even greater and psychologically more devastating. That expense is getting a divorce! Not only will have you have to potentially pay alimony, child support, and divvy up your assets, you may also have to pay wasteful lawyer fees! We’ll talk in more detail about the cost of marriage and divorce in future post.
Refinance Your Student Loan With SoFi
SoFi is a fantastic social lending company that provides rates as low as 1.9% variable with auto pay and 3.5% fixed with auto pay. The reason why they can offer lower rates than the rest is because they analyze you based on merit, quality of employment, and education besides just a credit score and financials. There is zero origination and prepayment fees. Offer terms are from 5, 10, 15, 20 years in both fixed and variable. Both private and public student loans can be refinanced.
Besides low rates, one of their best features is their unemployment benefits. If you lose your job while repaying your loans, you don’t have to pay your loan for up to 12 months while you look for a new job! Interest will still accrue, but having this cash flow break is a huge benefit. They also provide job assistance guidance as well. You can apply to refinance or apply for a new student loan here.
Photo by James Chan, Honolulu.
Updated for 2018 and beyond