01Know the Tax Code
You don't have to be a tax expert, but you should know how much of your income will go to the government.
As of 2019, income of less than approximately $132,900 per annum is subject to payroll taxes, consisting of government programs such as Social Security and Medicare. This payroll tax of 15.3% is paid half by the employee and half by the employer. Keep in mind, if you are self-employed, you are on the line for the full 15.3% on your own – so in addition to your regular income taxes, you are going to owe the federal government $20,333.70 on that first $132,900 of income.
The good news is half of your payroll taxes are deductible from your income taxes, but the net effect is that many Americans still pay far more than their stated income tax bracket would have them believe. As you get wealthier, the tax burden as a percentage of disposal income begins to decrease despite being higher in absolute dollars. In other words, if you make $800,000 and pay $300,000 in taxes, it’s not likely to hurt your standard of living, but if you make $20,000 and pay $3,500 in taxes, it might mean you can’t keep the heat on during winter.
It is during this time in one's life — when they are struggling to pay bills and still subject to payroll taxes — that it is most difficult to build wealth. Congress has provided several ways to get ahead in the tax code, notably through Roth IRA, Traditional IRA and 401k plans. In the case of the latter two, money paid in for investments is tax-deductible when it is invested. For example, if you contribute $5,000 to a 401k and you’re in the 24% bracket, you won’t have to pay $1,200 in federal income taxes on that money because, for the time being, as far as the government is concerned, it never existed. That means that right out of the gate, you have $1,200 working for you. If you were to take that money in your paycheck to attempt to pay your bills, you would only end up with $0.76 on the $1 due to the income tax bite.
02Go After Free Money
Likewise, if you are going to be in debt (which is not exactly ideal), make sure you go for the low-cost, tax-deductible, long-term, fixed-rate kind. Personal credit card interest isn’t tax deductible.
Let’s say you have a $15,000 balance and your cards are charging you 23% interest per annum. You are going to have to come up with nearly $3,500 per year just to cover the interest payments – and that’s not even paying down the principal! That money is not deductible on your income taxes or for your payroll taxes, meaning for most Americans earning less than $132,900 per year, you are going to have to make $5,200 pre-tax to cover your interest costs! That’s $200 per pay period if you are paid bi-weekly (26 times per year), or $433 if you are paid monthly. Think about that - $433 per month of your income just to service interest costs, without reducing the principal balance. For someone working 40 hours per week, 52 weeks per year, that’s $2.50 per hour just to maintain their debt load. That’s devastating to someone making $8 or $10 per hour. Now, talk about trying to not only pay down the debt, but put money aside for a better life and it gets to be daunting.
If your employer offers 401k matching, take advantage of it. In the above example, if you were to get dollar-for-dollar matching on the first, say, 5% of your contributions and you made $30,000 per year, you would get $1,500 in a bonus match deposited into your account. You already know that you saved $1,250 in taxes, so now, by simply putting $5,000 in your 401k, you have a total of $6,250 capital working for you — or $2,750 more than you would have had if you just took your regular paycheck, paid the taxes, and tried to money into a brokerage account! That’s nearly 79% more money at work for you!
03Create Cash Generators Just for Investments
One way to add more money is grow your income pie, not just try to cut more expenses from your existing lifestyle. If you have a talent or skill, maybe you could freelance on the side to pick up a couple hundred dollars per month — all of which can get dollar cost averaged into blue chip stocks. Perhaps you work in a factory — can you pick up extra hours? By bringing in more money, you’re funding your investments without touching your ordinary life. That’s very important because it’s more likely you’ll be willing to stay the course as you won’t feel deprived.
This may not seem like much, but if you can manage to put away an extra $10 per day from new business activities or projects, at 10% over 40 years, you’re talking about having more than $1.6 million! People aren’t trained to think like that, and our education system certainly doesn’t seem to give us these tools. You cannot attempt to put aside huge sums – fortunes are built $1 or $3 at a time. That money compounds, grows and builds. It’s just the nature of things. An acorn doesn’t become a mighty oak overnight, or even in a few years. It takes time.
04Simplify Your Life
For most people, clutter is not only messy, but also comes at a cost. This may not seem intuitive, but trust me on this one. Tax time is one of the best examples. People often lose out on tax deductions because they never catalog or file their receipts. This means more time — and money — needed for accountants and lawyers to sort out their affairs.
Consider the following helpful tips to avoid the craziness of trying to find paperwork or receipts at the last minute:
- Open a set of 26 hanging files, with a tab on each marked for each letter of the alphabet, A-Z.
- Every time you spend money, fill out a cover sheet, staple it to a copy of the receipt along with the original and file it by the vendor name in the appropriate file. If you spent $97.52 at Wal-Mart, highlight the tax deductible items on the copy (some thermal receipts will cause the lettering to disappear if you mark the document) and file it under “W”. At the end of the year, it becomes effortless to track your expenses and turn your files over for tax preparation.
- Throw out the stuff you don’t use. Seriously. Your life will feel cleaner once it’s gone.
- If you have sufficient assets to make financial sense, consider consolidating your entire financial life with a single firm. Many banks now have total-wealth services with checking, savings, money market, brokerage, insurance, mortgages and equity lines of credit, college funding, credit card, estate planning, and retirement services. Wachovia offers this under its Command Asset program, while UBS consolidates everything in its Resource Management Account. You can check with your preferred financial institution to see if it has a program that consolidates your everyday banking and investment needs into one convenient portfolio.
05Learn to Manage the Liability Side of Your Balance Sheet
A common mistake investors often commit is to focus only on the asset side of their balance sheet. But the liability side, where the debts are kept, is just as important. A question we often get is, “Should I pay off my debt or invest?” and the answer is simple: It depends. Even if you have millions of dollars in wealth, if you are fortunate enough to have core consolidated tax-deductible federal student loans locked in at 5% for the next twenty years, it would probably be a mistake to focus on paying those off due to the cost of capital. After factoring in inflation, the tax savings and the opportunity cost of investing in attractive assets such as a collection of blue chip stocks, paying this debt off at the expense of investing could result in millions of dollars of less wealth over long periods of time.
On the flip side, it makes absolutely no sense to invest in a regular brokerage account if you are paying 20% on a credit card due to debts you have accumulated in the past. It amazes me to hear people talking about taking vacations, buying Christmas gifts, picking up a new shirt or going out to dinner when they are swimming in a sea of high-cost debt.
06It's Important to Reinvest All Dividends
For those of you in the investment-know, this has been repeated ad naseum. The single most important factor in reducing long-term risk when you own a collection of high-quality, blue chip stocks is to reinvest the dividends. Professor Jeremy Siegal has shown in his work and books that this not only reduces the time it takes to gain back losses in down markets, but due to the dollar cost averaging effect, many investors experience better results as they are not tempted to time the market. Here is an excerpt from one of his books:
"Between 1950 and 2003, IBM grew revenue at 12.19% per share, dividends at 9.19% per share, earnings per share 10.94%, and sector growth of 14.65%. At the same time, Standard Oil of New Jersey (now part of Exxon Mobile) had revenue per share growth of only 8.04%, dividend per share growth of 7.11%, earnings per share growth of 7.47%, and sector growth of negative 14.22%."
Knowing these facts, which of these two firms would you have rather owned? The answer may surprise you. A mere $1,000 invested in IBM would have grown to $961,000 while the same amount invested in Standard Oil would have amounted to $1,260,000 – or nearly $300,000 more. This would happen even though the oil company’s stock only increased by 120-fold during this time period and IBM, in contrast, increased by 300-fold, or nearly triple the profit per share.
The performance differences come from those seemingly paltry dividends: Despite the much better per share results of IBM, the shareholders who bought Standard Oil and reinvested their cash dividends would have over 15-times the number of shares they started with while IBM stockholders had only 3-times their original amount. This also goes to prove Benjamin Graham’s assertion that although the operating performance of a business is important, price is paramount.
07Keep Costs Low and Consider Indexing
When you start small, you have a major disadvantage as your economies of scale just aren’t present. You can’t afford to pay a $12 or $25 commission every time you have $500 to invest — it will devastate your principal, meaning there is less money at work for you. That’s one of the reasons it often makes much more sense for an small, average investor to simply dollar cost average into a rock-bottom cost index fund offered by an industry giant such as Vanguard or Fidelity.
Signing up for these plans can be done on each company’s website and all you have to do is pick the fund in which you are interested (most advisers prefer low-cost index funds that mimic the S&P 500), then link it to a checking or savings account so that automatic, regular withdrawals are made at pre-determined dates. This takes the guesswork out of managing your portfolio as you are essentially buying “America Inc.”
How to Amass the First $100,000 of Your Portfolio
No statement has better summed up the emotional and practical struggles confronting average people attempting to build a better life for themselves and their families than a saying attributed to a very successful investor. Charlie Munger — now one of the wealthiest men in the world with a fortune estimated at more than $2 billion — said, “The first $100,000 is a bitch.”
Pardon the language, but speaking from my own personal experience, I unequivocally agree and attest to that fact. Part of this is the result of the tax code. Part of it is the very nature of compounding, where simple math tells you a 10% return on $1,000,000 is $100,000. The third part is experience. Imagine the time, effort and heartache you could save yourself if you could go back and speak to your 15- or 16-year-old self and pass on knowledge about money and life in general.
In this step-by-step — part of The Complete Beginner's Guide to Saving Money — I’m going to give you some general tips to help you get started on the road to putting aside your first $100,000 in investment capital, free and clear. Of course, laws and customs vary by state, region and country, so none of this constitutes investment, tax or legal advice — and you need to consult your appropriate professional to ensure that a particular strategy, structure or course of action is right for you. In the end, my hope is that it will make saving and investing just a little bit easier.