Personal Finance Tidbits You’re Just Not Getting Right
The two main components of personal finance are saving and earning. How to save and earn the most can be as complicated as you want it to be. Starting with the wrong understanding of basic personal finance concepts can be like digging a hole with a rake instead of a shovel.
Income Tax Brackets
It is foolish to avoid making extra money because it might bump your income into a higher tax bracket. The Internal Revenue Service does not to charge the same tax rate for all of your total income. Below are the tax brackets for a single person in 2016.
- 10% – $0 to $9,275
- 15% – $9,275 to $37,650
- 25% – $37,650 to $91,150
- 28% – $91,150 to $190,150
- 33% – $190,150 to $413,350
- 35% – $413,350 to $415,050
- 39.6% – $415,050+
Many people assume the IRS taxes their total income based on their peak income tax rate. The reality is the IRS calculates the income tax amount based on each tax bracket not just the peak bracket for a taxpayer. If an individual makes $37,000 in income this year, the IRS will not charge him 15 percent on $37,000.
The IRS will charge 10 percent for the first $9,275 earned. The individual would pay 15 percent on the remaining $27,725 of income.
If the individual makes say $1,000 more than $37,650 in 2016, the IRS will charge him 25 percent only on that $1,000. The rest will be charged according to the lower corresponding tax brackets.
Those who want to do more math, can calculate their effective tax rate, as Sean Williams explains on The Motley Fool. The important thing to remember is making extra income will not mean you are lowering your total hourly pay rate. Only $100 more goes to the IRS on that extra $1,000 in the example because of the higher tax rate. You get to bank $750 for the extra work.
Investment Gains and Taxes
The misconception that investors have to pay income tax on an entire investment may come from the human tendency to automatically focus on the biggest number. Profitable investments have two parts: the initial investment amount and the amount gained. The IRS only taxes the gains.
There are two types of gains: short-term and long-term. Short-term gains come from investments held less than a year. Those gains will be taxed at the taxpayer’s peak tax bracket rate.
Long-term gains come from investments held more than one year. The IRS uses a different a set of rates to tax those gains based on a taxpayer’s current income tax bracket.
0% tax – $0 to $37,650 total 2016 income
15% tax – $37,650 to $415,050 total 2016 income
20% tax – $415,050 or more total 2016 income
The reality for those making at least $37,650 a year is they are paying less for long-term capital gains than they are for regular income. There are strategies to decrease your long-term capital gains taxes that Tom Tauli of InvestorPlace discusses.
401(k) Tax Surprises
People tend to ignore negative details. Yes, contributing to an employer’s 401(k) plan has many advantages. The IRS says employees can contribute up to $18,000 of their paycheck a year without penalty. The contributions are pretax, so they lower an individual’s gross income.
The employer may match the employee’s contribution by a certain percentage. The company match is like free money, so it makes sense for an employee to at least contribute enough to get the company match.
The thing people ignore is the IRS will eventually tax them for their 401(k). The IRS has a bunch of rules for 401(k) distributions. Essentially, retirees will have to pay income tax on the money they cash out of their 401(k) at the income tax rate they face during retirement. Early distributions have even more tax surprises, so individuals should think carefully before cashing out or taking a distribution before they turn 59 ½.
Buying vs. Renting
This argument is a popular selling point for real estate agents. Circumstances dictate whether investing in a residential property is better financially than renting one.
Buying a house for most people should be about fulfilling a need for permanent residence. The chances an individual can flip a house for profit in the short-term usually are slim. The local housing market needs to be on fire.
The equity argument also requires a climbing market. Principal payments on mortgage loans can build equity and so can rising property prices. In a down market, homeowners get no equity.
The mortgage loan can be upside-down meaning the current market value for the house is less than the price the homeowner paid or even owes. That’s when the lender freezes the home equity line of credit because there is no equity.
Chances are if investors compare the monthly cost of living in a property they own vs, rent, they will find renting is less expensive.
Tax Refunds and Interest
If a personal finance enthusiast gets a big tax refund from the IRS, he has failed. Overpaying income taxes on each paycheck is like giving the government an interest-free loan.
This situation requires immediate, real tax planning and action. Taxpayers should adjust their W-4 to make sure the government does not take out too much from their paychecks. Download the editable PDF from the IRS, and bring it to your human resources department, today.
Paying less in taxes per paycheck has many advantages for an individual. The extra money can be invested, put in a savings account or used to pay down debt.
What Really Makes You Happy
Of course, money does not buy happiness, but it can make life much easier. Being debt free and having money in reserve for short-term expenses and retirement can change a person’s outlook.
Think about the last time you left a job. While you were there, you probably focused on the positive aspects of the situation. After you left, your perspective changed. You were free to admit to yourself at least that things weren’t so great at that old job.
Perspective is what delivers happiness. A millionaire can be unhappy because he has no friends. Down the street, a dude living in a trailer can be happy because he has what he wants.
Working hard on saving and earning and then finding out you’ve been doing it wrong can be discouraging. It’s important to get the basics right to avoid face-palm moments. With those out of the way, personal finance enthusiasts can focus on improving their lives.