Six Essential Personal Finance Facts That People Are Constantly Wrong

Posted on January 18, 2016 by resourcefulman

Quite often, the “facts” that people advertise when it comes to personal finance are not facts at all. Sometimes they are simply authoritative opinions based on incorrect information or assumptions. Is it any wonder when such confusion arises, when many financial principles contradict intuition?

This post was originally published on The Simple Dollar .

Every week I get quite a few questions from readers (usually from my personal Facebook page ), many of which end up in the weekly Reader’s Inbox .

While most of the questions are quite interesting, I find many patterns in the questions I am asked. I see a lot of people struggling with a huge amount of student loans and credit card debt, for example, in the early years of their professional life, and this situation really hit me.

Another thing I regularly see is questions from people who are confused by some aspect of personal finance because they have this or that fundamental fact about the situation that is completely wrong. I’ll give you an example: maybe once a month I’ll get angry with a message from someone telling me that I sell snake oil, telling people to make a little more money in their spare time, and that I need to advise people to keep their income low. so that all their money is not spent on taxes.

What nonsense.

Here are six key financial facts people get wrong all the time. They use these facts as guesses, not only for the questions they ask me, but also for how they behave in everyday life.

1) A higher tax bracket does not mean that all of your income is taxed heavily

To start this discussion, let’s take a look at the 2016 tax brackets for one person.

10% – from 0 to 9,275 dollars 15% – from 9,275 to 37,650 dollars 25% – from 37,650 to 91,150 dollars 28% – from 91,150 to 190 150 dollars 33% – from 190 150 to 4 13,350 dollars 35% – from 4 13 350 to 4 15 050 USD 39.6% – 4 150 50 USD +

Let’s say you make $ 37,500 a year. You are just inside the 15% tax bracket. What happens if you do more?

The misconception is that if your income rises to $ 38,000 a year, you will have to pay 25% income tax on your entire paycheck. In other words, it is estimated that if you earn only $ 500 a year, your income tax will increase from 15% of $ 37,500, which is $ 5,625, to 25% of $ 38,000, which is $ 9,500. With this misconception, getting $ 500 more will actually cost you $ 3,875. Obviously making a little more money here would be a huge mistake.

But that’s not how taxes really work.

In fact, when you make $ 37,500 a year, you pay 10% in taxes on the first $ 9,275 of that (in other words, the first $ 9,275 of your income) and 15% in taxes on the remaining $ 28,225 (since the rest goes to this amount). $ 9,275 to $ 37,650). This adds up to a tax bill of $ 5,161.25.

If your income rises to $ 38,000 a year, the math will change little. You still pay 10% in taxes on the first $ 9,275. You pay 15% tax on the amount between $ 9,275 and $ 37,650. You pay 25% in taxes on the remaining $ 350, which is between $ 37,650 and $ 91,150. This adds up to $ 5,271.25.

In other words, increasing your income by $ 500 in this situation only adds $ 110 to your income tax. You still have $ 390 left.

There is never a situation where an increase in your income means you have to give all of that increase to the government in taxes. Ideas like this come either from people who struggle with math or from people who are trying to mislead you.

2) When you sell an investment, you must pay taxes only on the profits, and not on the entire

Let’s say you put $ 100,000 from your checking account into something – maybe stocks . These investments bring in $ 150,000. But then your uncle tells you to be very careful with this money, because you owe a lot of taxes on it.

Should you worry? Maybe a little, but this is not a dark scenario.

The misconception is that when you sell an investment, you will have to pay taxes on all the money you receive. Let’s say this is an investment taxed at a 15% rate, so according to this misconception, when you sell this investment for $ 150,000, you will have to pay $ 22,500 in taxes. This will eat almost half of what you purchased, and if that were the case, your uncle would be right. It would be painful.

But this is not the case.

In fact, when you withdraw money from an investment that is not in any special account, you only pay taxes on the profits . You get your original investment back tax-free. So in this example, if you sell that $ 150,000 in stock, you get your $ 100,000 without taxes, and you only have to pay taxes on $ 50,000. At 15%, as described above, that’s only $ 7,500, not the incredibly painful $ 22,500 your uncle might have believed.

Of course, there are tax implications for the sale of an investment, but you just don’t have to pay taxes on the amount you originally invested, unless something very unusual happens.

3) Investing money in your 401 (k) doesn’t mean tax-free income, it just means you pay taxes later

I have a friend who acts like he’s investing in 401 (k) – kind of a secret ninja tax ploy. He takes great pride in the fact that every dollar he puts into his 401 (k) is a dollar of income that he doesn’t have to pay taxes on this year.

And he is absolutely right. It’s true that the money you put into your 401 (k) is money that you don’t have to pay taxes on this year. But the key word is this year . Let’s take another look at these tax brackets:

Let’s say you make $ 40,000 a year. If you don’t put anything into your 401 (k), you will pay $ 5,771.25 in taxes this year. But suppose you contribute 10% of your salary to your 401 (k). In this case, your tax debt will be only $ 4,936.25 because you will only pay taxes on the remaining $ 36,000. Your taxes are actually reduced by $ 835, which means that the $ 4,000 you save is actually only costing you $ 3165 in terms of the salary you receive. Sweetheart, huh?

But these taxes are not freebies. As you age and retire, you will start getting money out of that 401 (k) and it will be taxed like regular income.

Let’s say you earn $ 20,000 a year from other retirement benefits in your old age. The total income taxes will be $ 2,536.25. However, let’s say you are also withdrawing $ 4,000 per year from your 401 (k). This increases your income to $ 24,000 per year and thus increases your taxes to $ 3136.25. That’s an additional $ 600 in taxes.

401 (k) does not mean that money is tax-free. It simply means that you will pay them later when you collect the money. Hopefully your tax rates will be lower at this point (due to changes in government or changes in personal income), in which case 401 (k) will save you some tax money in the long run, but this is not a guarantee.

4) Renting is more than just throwing money away, and buying a house won’t make you rich with “equity”

One of the central tenets of the American Dream is that in order to establish yourself financially in the world, you need to buy a house. Add to this the real estate bubble in the 2000s and the stream of reality TV shows and fast-release books that talked about how to get rich by buying a house and turning it upside down, you have a lot of people firmly convinced that they have to buy a house in order to have some kind of financial success.

Don’t get me wrong – a home can be a good investment in the right situation. It’s just not the right choice for every situation.

On the other hand, it seems that renting a house or apartment is just a waste of money. This means that you are not wasting money in the process of buying and paying for your home – and most likely you are. Let’s compare the two.

When you rent a property, you have to pay for it and also for the renter’s insurance, which is pretty cheap. This is the money you lost.

On the other hand, when you buy a home, you have to pay the final costs on the original purchase. After that, you must pay your mortgage bill (most of which is interest), homeowner’s insurance (which is more expensive than renters insurance), property taxes, homeowners association fees, and the cost of maintaining your home. All this money disappears – usually much more than the cost of the rent. In exchange, you get a small fraction of the home equity in your home – no matter how much the value of your home rises (assuming you’re in a decent housing market) and the amount of the mortgage principal you actually pay off. every month.

It is absolutely not cut and dried, as in which situation is better. In fact, this varies quite a bit, as there are many specific situations where renting makes more financial sense, and many specific situations where buying a home makes more sense.

How do you determine what is right for you? In general, the time to buy a home is when you are financially secure enough that you cannot easily lose your home to an ordinary event or two.

Do you have a healthy job with money in the bank? That’s when you should consider home ownership. If you take on this without a stable job or without significant savings, and something goes wrong, you will not only lose accumulated capital, but also lose credit for a very long time.

5) High tax refunds cost money

One of my oldest friends posts every year on Facebook about how big his tax refund will be. He actually turns it into a few posts where he talks about filing, waiting for a refund, getting a refund, and then using it for something or other. Receiving a $ 3,000 refund seems like one of the highlights of his year. I don’t have the heart to tell him that he is actually being ripped off.

Every dollar of that tax refund is a dollar that he paid in the previous 12 months (or so). This is because a tax refund is simply your money being given back to you – it’s additional taxes that you deducted from your paycheck during the year.

Let’s say a friend of mine has, say, $ 100 deducted from each weekly paycheck for a year. This adds up to $ 5200. Its actual taxes at the end of the year are $ 2,200. So he gets a refund of $ 3,000 because he paid $ 3,000 too much during the year.

Now let’s look at another plan. Let’s say my friend has, say, $ 45 deducted from his weekly paycheck for an entire year. This adds up to $ 2340. His weekly salary is now $ 55 more. Since his actual taxes at the end of the year are $ 2,200, he will now receive a $ 140 refund.

Why is the second scenario better? Let’s say my friend puts money on his credit card to make ends meet. That $ 55 can prevent this type of credit card use by saving him more money by avoiding credit card interest. If he is more responsible financially, he could save or invest that money himself. Even if you put money in a savings account, he will receive 1% of that money, so he will have more money to spend next April. He could also do something like investing in Roth’s IRA for retirement so that it generates much higher returns (7-8% on average).

There is another important factor: in the second scenario, he has the flexibility to use this additional money throughout the year. If he puts them in his savings account, and then, in November, his car breaks down, he can just pay for it in cash. This is an emergency fund. On the other hand, he could use it to fund Roth’s IRA and get a nice chunk of retirement changes before his tax refund ever arrives.

The only benefit of tax refunds is that it serves as an interest-free savings account for people without personal willpower to save. I suppose this may be important to some, but just because you use tax refunds effectively as a savings account does not mean that the government is offering a great savings system. This means that you are sorely lacking in personal willpower, and you pay for it by losing the potential profit and flexibility you could gain by saving that money yourself.

[Edit: Fixed to distinguish between tax returns and tax refunds.]

6) If you are unhappy, what you need most will not make you happy.

Over and over again I will hear from readers who seem completely unhappy in their daily life. They work the job they hate. They are unhappy in their personal lives. They are mostly afraid to get out of bed in the morning.

I hesitate to use such questions very often in my inbox for readers, because I am really not interested in turning this article into a big “oppressor”. But questions still remain.

The questions they share are usually about figuring out how to achieve some goal in their life. They decided that something new – maybe a new car or a new house – would bring joy to their lives and completely change the situation.

“My life is miserable, but I really hate commuting. I am thinking of buying a luxury car to make everything better and it will extend to my whole life. Help me figure out how to do it. “

I get this message quite often. It has never been written so bluntly, but the idea comes down to just that. Their life makes them miserable, but they decided that a new laptop, a new car, or a new house would fix everything. Will not be.

Getting what you’re fixated on, whether it’s your car, home, laptop, or whatever, will bring you an explosion of joy, but that surge is fleeting . Soon, your life will return to its former routine. You will continue to get to the same place. You will still come home to the same people. You will have the same habits and routine of life.

Buying something big and new won’t change any of that.

These questions are related to two important truths. First, the way you spend your time influences your happiness much more than what you own.

You can be incredibly happy and content in a seedy shack. In a mansion, you can be incredibly unhappy and unhappy. The question is whether you spend your time with people you care about, and whether they enjoy their company (and people who care about you and enjoy your company), do you have hobbies and leisure activities that make you feel satisfied, and whether you allow challenging tasks. areas of your life – and everyone has them – to overshadow everything else.

Second, whether you should choose you to be happy is also a vital factor in your own happiness.

What do you think about when you think about life? Do you see negative or positive in things around you? Do you see an awful drive to work or an hour where you can listen to NPR, an audiobook or music and just relax and learn something new or shake your head to the music? Do you see the pitiful work with unhappy people, or do you see a great opportunity to make more money than the vast majority of the people in the world will ever see in their lives, when all you have to do is sit in the office?

Naturally, there is a component of mental health here. Anyone who has persistent negative feelings about significant portions of their life should at least speak with a mental health professional to find out if there is a biochemical issue that is causing these feelings.

After all, you choose your life for yourself. For the most part, you decide how much you like it. If you are unhappy, buying something new will not make you happy.

Final thoughts

Quite often, the “facts” that people advertise when it comes to personal finance are not “facts” at all. Sometimes they are just authoritative opinions. In other cases, they are based on incorrect information or assumptions.

In any case, it is always worth sitting down and thinking about why you are making this or that personal finance choice. Why exactly do you want a big tax return? Where do you think the money is going if you are making less profit instead, and why might a larger profit be better than that?

There has to be a real reason for every dollar you spend and every hour you spend . When you dig in and understand this reason and then try to spend that money and hours in a positive life, you will always find yourself in a better place.

Good luck finding the truth!

Six Essential Personal Finance Facts People Should Know (But Always Get It Wrong) | Simple dollar

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