Hello frigid February!
Is it just me, or is 2019 flying by for you too?
In our three-part new years series last month, we explored what creates good financial health.
We saw the impact that seemingly insignificant day-to-day spending has on reaching really big long-term goals. And we learned that the backbone of wealth creation rests on establishing small but consistent habits that increase over time.
Hopefully an idea or two stood out for you. Did you make some changes in the way you manage your money? I encourage you to take a couple moments to share your experience in the comments below. I’d love to hear what’s actually working for you.
Moving forward, let’s dive into another financial concept…taxes.
Don’t worry, I won’t be boring you with mind-numbing calculations. I’m about as much of a fan of algebra as you are! My sole intention is to help you understand how the concept of tax alters the value of money.
From an empowerment perspective, we want to use tax to accurately assess our true buying (and savings) power.
So, let’s begin. What’s your income tax rate?
If you pay 30% in income taxes, it means that spending (or saving) $1 is equal to earning $1.30! A 40% tax rate means that theoretically you’d need to earn $1.40 to buy something that costs $1. A sobering thought, I know.
Now a dollar here or there might not feel like much, but at 30% it’s a difference of $3,000 on $10k, or a whopping $30,000 on $100k of income. If you’re earning 6 figures, your tax bracket is even higher.
It must be said that this simplified idea assumes you aren’t doing everything in your power to reduce your taxes. It’s your legal right to do so – and I absolutely encourage you to take full advantage of it. You can drastically reduce your tax payable. But I’ll leave that to the expert accountants. For the sake of this article, we’re focussed on increasing your awareness of how tax diminishes your buying power.
Unfortunately, this is only half of the equation.
What’s your sales tax rate?
Depending where you live, it could be 0% if you’re very lucky, or as high as 20%.
So, at a 30% income tax rate, that designer bag you’ve been eyeing doesn’t really cost $300. It’s $390…plus sales tax. That could easily add another $30-$50 on top.
This is why so many of us struggle to save money.
Our minds think only in terms of pre-tax dollars, yet life costs post-tax dollars.
It’s also one of the reasons investing is so important. We can counteract the negative effect of tax (and inflation, for that matter) by generating more income. However, since that money hasn’t been created yet – and may not be guaranteed, a dollar saved today can be considered to be more valuable.
Is it all doom and gloom?! What can we do about it?
Hiring a great accountant is your best defence against high income tax. But we can also control how much sales tax we pay. Buy new or gently-used items second-hand from individuals, as opposed to companies. No tax is charged. You’ll also spend less. In supermarkets in many countries, buying fresh fruits and vegetables is tax-exempt, while packaged food is not. Travelling soon? Consider buying expensive items abroad in a lower taxed country, if possible. It pays to know the law.
The lesson here is use the reality of tax in a positive way to help us make better spending choices. First we need to retrain our brains to compare apples to apples. It might piss us off at first to look at the numbers. But it’s important to remember that so many of our day to day choices naturally improve with awareness.
Whether we love ‘em or hate ‘em, taxes are a fact of life, so why not use them to our advantage?
I want to leave you with a takeaway today.
Here’s a quick formula you can use to calculate the actual cost of anything.
a. Know your income tax rate (or your modified rate, based on your accountants’ nifty work). If you don’t know the number, look it up from last year’s filing.
b. Know the sales tax rate where you live.
c. Add these two percentages together. Let’s say your modified income tax rate is 18%, and your sales tax rate is 10%. Your total is 28%.
d. Take the item cost, whether it’s food, a car, or clothing and multiply it by this combined rate. Say the item is $400. Your formula is $400 x 1.28 = $512. That item actually costs you $512 in pre-tax earned dollars.
I know this can feel like a total downer. But I’m a realist. And an optimist. It’s important to work with the accurate picture so we can manage our financial resources in a much healthier way, and then seek ways to build on top of a strong foundation.