It’s not totally uncommon to talk to prospects or clients that make several hundred thousand dollars a year, and they don’t know where all their money goes. Ex: We make $300,000 per year, but don’t really have much savings to show for it. Here’s why I think this happens:
The more someone makes, the more discretionary items/services seem within reach. I.e. “I just got a big raise, I think we can afford to ___________ (hire a cleaner / take more trips / fill in the blank).”
In reality, the more you make, the more taxes you pay. For a family of five and 100k of income, their estimated 2021 federal tax is $2,590. A whopping effective tax rate of 2.59% for federal taxes (assumes 3 kids getting the child tax credit and the family taking the standard deduction). If that same family works hard, progresses in their careers, and eventually has 300k of income, the same family of five would then pay $48,468 in federal income taxes.*
Their income went up by 3x. Their taxes went up by 18.7x
Although discretionary items seem within reach, they actually cost a lot more when you factor in taxes. Let’s look and see (assuming a 35% federal rate and 6% state rate = 41% combined rate):
To determine the true “tax adjusted” cost, you’ll need to divide the expense by (1 minus marginal tax rate).
Housekeeper: $350/mo is what you pay: True cost = $350 / (1 – .41) = $593 per month
Car payment: $600/mo is what you pay: True cost = $600 / (1-.41) = $1,016.95 per month
Hamburger: $12 is what you pay: True cost = $12 / (1-.41) = $20.34
The takeaway: As your income rises, you should increase your discernment of non-deductible expenses as their cost increases on a tax-adjusted basis. The next time you eat a hamburger, you might realize that everyone in the restaurant is paying a different price (depending on their tax rate!).
*Estimated tax rate determined using the following calculator: https://equitable.com/retirement/products/variable-annuities/investment-edge-annuity/estimate_your_effective_tax_rate