By Yichen (Anna) Xing, IV Form
After graduation, many get their first formal job and start making money, but only a small percentage of young adults have the intention to manage their savings. Various reasons lead to the unawareness of the topic of personal finance, including the lack of financial education in high school, help from parents, or people who are simply ignorant of the benefit of having a lifelong savings plan. Some may question the necessity of developing a savings plan because they think they can live without worrying about going bankrupt, however, life is full of variables and uncertainties. As an introduction for beginners, this essay will provide an overview of topics related to personal finance, covering tax and benefits, tax deferred savings, interest rates, cost of living, investing, insurance, and housing.
To make a lifetime consumption plan, tax and benefits are always crucial factors to incorporate into your calculations because they are influential in many aspects of life. The most common tax categories include income tax, employment tax, sales tax, property tax, and estate and gift taxes. Personal income tax applies to most forms of income and increases with income. To calculate one’s after-tax income or the available amount for consumption, both federal and state tax rate needs to be incorporated based on the corresponding bracket. For example, if one earns $100,000 annually and lives in Massachusetts, that person will pay $14,605.50 plus 24% of the amount over $85,525, which is $18079.5 for federal tax and 5% of $100,000, which is $5000 for state tax. Employment taxes are used to fund social security and Medicare, also called FICA. For employment tax, employers and employees split the tax, each paying 6.2% for social security and 1.45% for Medicare, totaling up to 7.65% of their income. In this case, the hypothetical person will pay $7650 for employment taxes. For those earning high incomes, employment taxes have an upper limit of $142,800. Unlike income and employment taxes, sales tax is mainly based on state levels. Sales tax applies to most goods and services in the form of a given percentage of the price but with many exemptions. Alaska, Delaware, Montana, New Hampshire, and Oregon currently have no sales tax. There are also tax-free weekends in 16 other states with different dates and rules. Property taxes include both residential and commercial properties and follow the state’s tax system with various percent based on the local city or town. This is a key aspect to put into consideration when deciding where to buy or rent because owning a property brings an extra financial burden. Estate and gift taxes are paid upon death and are applied at the federal and state levels. It is a relatively minor topic because according to the federal system, only gross assets that exceed $11,700,000 are subject to paying estate and gift taxes, with one exception of Florida, which has no estate tax.
Thus far, we have been talking about money being taken away. So this begs the question, why are people paying these taxes and where does the money go? A majority of the taxes in the United States help to fund defense and security, public schools, health programs, Medicare, Medicaid, interest on the national debt, and safety net programs like food stamps, disability insurance, unemployment insurance, and most importantly, the social security benefits that help support people in retirement. The amount of benefits a person receives in retirement depends on their lifetime earnings and when they choose to start benefits. Higher lifetime earnings can mean higher benefits and vice versa. To receive full retirement benefits, people start to receive them at the age of 67. However, one can choose to get the benefits as early as the age of 62, but the benefits will be reduced accordingly. Some people choose to postpone their benefits beyond their retirement age because benefits will continue to increase up until the age of 70. As has been noted, taxes are important factors to evaluate not only because they take away a non-trivial amount of money, but also because they can be an effective way to save for retirement.
Tax-deferred accounts are one of the ways to earn a return from savings and achieve the ultimate goal of saving for retirement. Tax-deferred savings accounts allow taxpayers to postpone paying taxes to a later date when one possibly qualifies for a lower tax rate after retirement. The two common ways of tax-deferred savings are 401k plans and traditional IRAs (individual retirement accounts), both of which grow tax-free. However, distributions from both accounts are typically taxed at the rate of your retirement income. Both 401k and traditional IRA have penalties on early withdrawals, but 401k offers hardship withdrawals or loans that are taxed at the income rate, whereas IRA does not permit loans. 401k plans are offered by employers to their employees. Employees often contribute a portion of their salary into their 401k accounts and employers may match employees’ contributions, meaning that employers contribute a certain amount of money based on how much the employee contributes. In return, employees will have a lower tax rate because their salary is withheld and contributed to the account. In 2021, the upper limit of contributions is $19,500 for those younger than 50 and 26,000 for age 50 and older. Traditional IRAs are opened by individuals and do not have employer matchings. IRAs offer more investment options than 401ks, including stocks, bonds, CDs, and real estate. However, IRAs have a lower annual contribution limit of $6000 for age under 59 and $7000 for people 50 and over. Roth IRA is a different type of tax-deferred savings account that has no tax deduction in the current distribution year but distributions after retirement are tax-free. To add in real numbers, 401k plans usually have an annual return rate of 5% to 8% while IRAs have an average annual return of between 7% and 10%. People choose one of the accounts based on how much money they want to contribute and how much time they have to manage their accounts. So how much should one contribute? Generally, high earners max out their accounts and low earners contribute depending on how much they want to consume during their working life. Keep in mind that tax-deferred savings accounts are safe ways to earn benefits, so they will have a modest impact on your wealth. Other ways of earning higher returns also mean accepting higher risks.
Numerous investment options use rates of return so it is helpful to understand how to calculate using interest rates. Interest rate refers to the price one pays to borrow money and the return one receives for lending money. Though rates vary for different financial assets, it is usually a number like 2% or 5%. Yet some assets have substantially higher rates and some even have negative rates depending on the risk of return. One example of an asset is a bond or a debt contract. Buying bonds means lending money to the issuer and earning interests in return. Other assets like pure discount bonds, coupon bonds, stocks, and real assets have different forms of return. Pure discount bonds are when the borrower promises to pay the lender back a certain amount at a future date in exchange for getting a number lower than the future amount. The equation used to calculate the return is (future amount – the amount paid)/amount paid). This kind of return known as capital gain comes from price appreciation of the asset. Coupon bonds are another form of bond that earn periodic interest in addition to capital gain. Stocks are shares that represent divided ownerships of a corporation and pay dividends to shareholders. With dividends, the return formula changes to (price sold(future) – the price paid+dividend)/price paid, which exceeds the capital gain. Examples of real assets include houses and cars. The return of selling a house involves capital gains or loss from change in price, property taxes, depreciation, and forgone interest, meaning that the money could have been invested in bonds or stocks which will earn interest. To compare, selling a car has a much higher rate of depreciation. To calculate the current value of an amount that is received on a future date, we use the present value (PV) formula, PV=FV*1/(1+r)^n, with r representing the rate and n representing the number of periods. Up to this point, we have been ignoring inflation, a general rise in price that decreases one’s purchasing power. If inflation is 10% and your nominal return is 10%, that means you earn a 0% real return. From this, we can conclude that a reasonable return rate is likely to be small.
To develop a consumption plan we need to estimate the cost of living, which can be categorized into food, housing, health care, transportation, clothing, entertainment, and family. There are definitely other costs depending on personal interests and other factors, but for the moment, we will put aside the smaller costs. Before exploring each of the categories, we first need to understand the difference between consumption and expenditure. Consumption, specifically in economics, means the amount of resources used up that are not available for future use. Expenditure means the amount of money spent in a given amount of time. An example of expenditure versus consumption would be spending $2000 on a washing machine or a Red Sox ticket. These two things have the same expenditure of $2000 but different consumption because a washing machine lasts about 10 years but a ticket only works for once. As consumers use up different goods at different rates, the calculation can be confusing if we assume consumption equals expenditure. A better and clearer way to calculate the rate of consumption is to view all goods and services as durable or non-durable, then convert expenditure into consumption flows. Non-durables include services like haircuts, doctor visits, and trips to the nail salon. Goods that last for less than three years like cosmetics, food, and medicine are also non-durables. Durable goods are things like houses, cars, and furniture that cost about 5% of their price per year from maintenance and taxes. Food, a part of everyday life, can take up about 12.8% of one’s income. One’s preference of whether they like to cook at home or eat out in restaurants has a substantial impact on the amount spent on food because restaurants are more expensive but save you time from cooking every meal. To briefly talk about housing, a major expenditure, there are many things to consider like amenities, electricity, heat, parking, and location which influence commuting cost and time. A rough estimate suggests spending about 30% of pre-tax income on housing per year. The cost of transportation varies if one owns a car or takes public transportations like the subway. The amount spent on clothing varies depending on where you buy your clothes and how often you change them. Health is a major concern of most people and even with health insurance, there are deductibles you need to pay. Travel and entertainment are less important but can still use up a large amount like taking vacations. Lastly, dependents like family members are potentially huge investments. For instance, raising children is expensive and health issues with elders in a family can also cost a non-trivial amount. To conclude the cost of living, we need to recognize all the areas of consumption and the apt amount to spend for each of them to create a plan. We should consider the cost of maintenance and how long the goods will last when purchasing and consuming them.
Investing is presumably the most interesting topic because your savings can increase by a decent amount in the long term with different investment options. In previous topics, we covered how interest rates behave in riskless assets, but one can save by owning a variety of financial assets and real assets such as stocks, corporate bonds, foreign exchange, jewelry, bitcoin, real estate, etc. Assets refer to things that hold value over time and can measure their value at any point in time. For simplicity, we will focus on stocks, bonds, mutual funds, index funds, and ETFs. Stocks, again, represent partial ownership of a publicly traded company and pay dividends. There are many kinds of bonds like pure discount bonds, coupon bonds, and perpetuities, sold by different issuers including the government, corporations, and individuals. Mutual funds are collections of stocks, bonds, or other securities put together by professionals sold to the public in shares. An index fund is a type of mutual fund whose holdings match a given market index. In other words, buying index funds is buying a percent of the entire market which generally rises in value over time. Its market value is determined by the holdings of each stock. ETFs or exchange-traded funds are similar to mutual funds but traded on exchanges. Ideally, people predict the prices of stock and buy at a low price and sell at a high price to make money, but this is impossible because many others imitate these strategies and push the price up before you buy it. An important lesson from this is to not find underpriced assets and buy them. Instead, one should balance between risk and return of their portfolio. To achieve this one needs to hold both cash and a market portfolio with the maximum amount of diversification and adjust based on risk. As the Capital Asset Pricing Model suggests, one should keep buying index funds and never trade assets, then finally withdraw after retirement.
The current module has ignored the uncertain aspects of life and the standard way to reduce financial risk is insurance. Insurance is a contract created between an insured party and an insurer. The insured party pays a premium periodically to the insurer and in exchange, the insurer pays for the insured in certain conditions. Notice that insurance provides protection against large losses like unemployment, auto accidents, house fire, but it does not work for small and predictable things. The way insurance companies work is they try to average risks across people but occasionally this does not work because the insurer can not determine who is risky or not but the individual can. One other challenge companies face is people changing the way they behave after being insured like driving faster or developing unhealthy habits. Companies try to reduce these moral hazards by implementing deductibles, co-pays, limitations, and restrictions. Deductibles are the amount you have to afford before the insurance plan starts to pay. Co-pays are when the insured pays a portion of any covered loss. Examples of limitations or restrictions include limits on mental health visits, dental visits, cosmetic surgery. People get health insurance through their employer or the government. Employers often offer plans with low deductibles and high premiums or plans with high deductibles and lower premiums. Always choose the high deductible plans because they are usually better and out-of-pocket limits prevent you from paying too much. One thing everyone should do is self-insurance or saving more than they need in retirement because it is the other approach towards uncertainty.
Housing is a major expenditure and concern for most people and there are many questions as to how much to spend, renting versus owning, and the cost of owning. As mentioned before, the standard amount spent on housing is 30% of pre-tax income, but different factors such as school quality, distance from work, amenities, marital status, and children can influence the amount. Many think rent corresponds to apartments and owning corresponds with a house, but renting versus owning is a separate decision from to live in an apartment or house. Renting requires an agreement between the renter and the owner. Rules to carefully read over in the agreement are length of the agreement, monthly rent, who pays for miscellaneous, deposit, and credit history. Buying a house for a lot of people means borrowing money because the price exceeds their liquid assets but their lifetime income in total will be sufficient, so they sign a loan contract called a mortgage. Mortgage pays the seller full price together with the amount the buyer puts down and the buyer will own money to the bank after owning the house. A mortgage has a constant interest rate and takes equal payments each month or year. Other costs of owning are foregone interest, property taxes, maintenance, depreciation, and mortgage insurance. One final piece of housing advice is to choose an amount that fits your budget foreseeing all the non-obvious costs and do not think of housing as an investment.
This reading covers the basic rules in topics tax and benefits, tax-deferred savings, interest rates, cost of living, investing, insurance, and housing, giving people who want to make a lifelong saving plan or those interested in the area of personal finance a starting point. This guide hopefully can help you handle your current financial situation and be more aware of the aspects of life you have not considered. Personal finance is an essential life skill that will help you live a healthy, secure, and fulfilling life.