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Money Advice for Young People By Stephen J. Butler

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A neighbor mentioned last week that his son, two years into the work force, needed a referral to a financial planner who could help the young man learn effective money management. I think a lot of parents are seeking similar help for sons and daughters who have just begun careers.

It's tough to find a good financial planner who can afford to spend time with someone who has no money. Young people, though, have a huge advantage: time. Acting on good advice today can really pay off over the next fifty years of their income-producing lives.

I am, of course, billed as a retirement planner, so why am I talking about kids? It should be obvious. Someday, late in our own retirement years, we'll want our children to have sufficient resources to provide us with adequate assisted-living services when we move into their spare bedroom.

If you're a young person with a thirst for financial knowledge, you should focus on mastering five questions: 1) How are you being taxed? 2) Why is buying a home or condominium such a good idea? 3) Why should you be depositing as much as possible into a tax-deferred retirement plan? 4) What simple investment advice should you apply to these deposits? 5) How can you be street smart with the money you spend?

First, you need to understand taxes. A surprising number of life's decisions hinge on a basic understanding of marginal tax brackets --- what you pay in taxes on the last few dollars of income. Yet, the average young person is clueless on the subject. Too often I hear, "Hey, I didn't pay any taxes, I got $400 back in April." That's on par with, "How can I be overdrawn? I still have some checks left."

The average single young worker in California makes enough so that the last few dollars of income are taxed at least 25%. People make the mistake of taking total taxes paid and dividing by total income to estimate their "tax bracket." It may be as low as 10 or 15%.

But most financial decisions bump taxable income up a little or down a little. We take a new job, or stay put for a $200 per month raise. A raise, by definition, is the last few dollars of our income. It will be taxed at the highest level of taxes we are charged.

A tax table that combines Federal and state income taxes with Social Security shows that a single person's adjusted gross earnings that fall between $26,000 and $36,000 per year are taxed at 42%. Any dollars over $36,000 are taxed at over 45%, and it just gets worse after that.

Young married couples experience the infamous marriage penalty. Married couples must combine their incomes for tax purposes, which means that a couple's combined adjusted gross income that falls above about $44,000 will be taxed at 42%. If a couple with one working spouse makes $44,000 and the other spouse decides to go to work, the additional income will be taxed at a staggering 45%.

Why do taxes work this way? The Federal Government seeks to collect an average of about 17% from all of us. However, on the first $20,000 or so, they collect very little because the rate is low and there are many exemptions. If they get next to nothing on the first $20,000, they need 34% or more on the remainder to reach an average 17%. That's why all the talk about a flat tax hammered on 17% as the magic number. Then, we have to add State income and social security taxes.

As I said, many decisions in life add or subtract to total taxable income. An informed decision needs to consider how much of that additional income will disappear in taxes. Or, conversely, how much of this tax-deductible (income reducing) expenditure or investment will be paid with money that would otherwise have disappeared in taxes.

When we contribute to 401(k)s or IRAs, we remove from taxable income the last few dollars that would have been taxed at the highest possible rate. When we pay house payments instead of rent payments, we reduce taxable income because mortgage interest and property taxes are tax deductible. Rent is not.

When we take a new job because it pays $5,000 more a year, we need to know that, after taxes, we will probably only have an additional $3,000 of spendable income. That $5,000 gets taxed at the highest possible rate. When you calculate taxes this year, experiment with a few hypothetical income levels and see for yourself how much you pay on the last few bucks you earn. Remember to include all three taxes: Federal, state, and Social Security.

Owning a home creates tremendous tax benefits and financial leverage. In a simple example, the down payment of $20,000 on a $100,000 condominium buys an asset that could double in value over ten years if it appreciates at a rate of 7% per year. Ten years later, you sell the condo for $200,000 and pay back the $80,000 mortgage. You can keep the entire $120,000 profit you just made on your $20,000 down payment. Moreover, you do not pay taxes on this profit if you use the money to buy your next house. After age 55, you can pocket the rolling profit from a succession of houses without paying any taxes if you sell out completely and start renting again.

Meanwhile, if you can afford $1,000 per month in rent, you can now afford $1,500 in house payments, because $500 of that $1,500 will be paid with money you are otherwise paying in taxes. House payments, in the early years of a mortgage, are almost entirely tax deductible because they consist of interest and property taxes. They reduce your income for tax calculation purposes. In this example, a couple that pays $18,000 a year in house payments is saving at least $6,000 in income taxes.

While you're saving for that house, you should be maxing out contributions to your employer's retirement plan - even though retirement is decades away. Retirement plans offer tremendous tax shelter not just on the contribution, but on the tax-deferred compounding of earnings as well.

Figure it this way: $600 per month for 40 years at 12% builds to $7 million. A $600 contribution will cost most people about $400 in take-home pay, because $200 of the $600 is money that otherwise would have disappeared in taxes. And, $400 a month is less than the lease and insurance payments on a new VW Jetta. Keep the "clunker." In just ten years, $600 per month can accumulate to $140,000.

How do you invest this money? It doesn't matter. Forty years of time will correct any mistakes you make today. Any strategy that includes a mix of common stock mutual funds will work fine. Just do it, and don't worry about it.

Pray that the market plummets. When you invest regularly each pay period you are dollar-cost averaging. This mechanism keeps buying stocks automatically at bargain prices during a downturn.

Need money to go back to college or graduate school? Wait until you begin the calendar year during which you will not be working, and consider living on a portion of your retirement money. You will pay a penalty on what you spend, but if you're back in school full time, it will be your only income in that calendar year, and your tax will be minimal. Just don't take any more than the subsistence income that student life dictates. You should be too busy studying to splurge at the mall or to hang out in bars drinking cosmopolitans that cost seven after-tax dollars apiece.

A final piece of advice. When you watch the dimes, the dollars take care of themselves. Small amounts of daily expenditures become big ticket items over time. Writing down every dime you spend is one of the first defensive moves against runaway spending habits.

A movie actor with reckless spending habits was ordered by his business agent to keep track of every cent for a week. The results were: coffee $.50; phone bill $100; gas $10; miscellaneous $6,340. We can all do better than that!

"The Fitness Lifestyle" describes people who have the discipline to work out regularly and eat the right foods. What I call "The Financial Fitness Lifestyle" should appeal to young workers who embrace the concepts described above and apply them to decisions about careers, education, investments, and spending.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.