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More Advice for Young People By Stephen J. Butler

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Years ago, when my mother wanted to make a point, she would clip something from the newspaper whenever possible to provide the authoritative "third-party " source for her advice. Looking back at that subtle form of manipulation, I think it can be a more effective tactic than direct confrontation.

With the holidays just around the corner and young people getting together with parents, I thought I should update my "Advice for Young People" column in hopes that it may lead to scintillating conversation during commercial breaks.

A young person new to the work force needs to be coming to terms with six basic issues:

1) How am I being taxed and how does taxation affect career decisions?

2) Why is buying a home or condominium such a good idea?

3) Why should I be depositing as much as possible into a tax-deferred retirement plan?

4) What simple investment advice should I apply to these deposits?

5) How do I make sure that I always have adequate health insurance coverage regardless of my job or school situation?

6) And finally, how do I develop street-smart habits when it comes to saving money?

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 (and some older wage-earners) are clueless on the subject.

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 that you pay as low as 10 or 15% of your total income in taxes. For most decisions, this percentage is meaningless.

Why? Because 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.

If you create a tax table that combines Federal and state income taxes with Social Security and Medicare taxes, it will show 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. This explains why, when we receive a raise, our "take-home pay" rises by far less than what we understood to be our gross increase in income.

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. If your income drops because you cut back on work hours to go back to school, you may not be giving up that much after-tax income. What you gave up were those last dollars taxed at the "confiscatory" rate we have been talking about. 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 four taxes: Federal, State, Social Security and Medicare.

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.

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. In other words, the government is effectively paying $6,000 of your annual house payment.

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 car; keep the "clunker" and in just ten years, the $600 per month will have accumulated to $140,000.

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

In fact, pray that the market plummets. When you invest regularly each pay period you are dollar-cost averaging. This mechanism keeps us 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.

When it comes to health insurance, moving from job to job and/or back to school leaves you dangerously exposed to the possibility of no coverage. Nobody in America today can afford to be in this situation. The trick is to get a cheap, high-deductible policy, because the cardinal rule of smart insurance buying is to never insure something you can afford to pay for yourself. We can all somehow manage to round up $2,000 to pay medical bills, but $50,000 to $500,000 for a real serious illness or disease would wipe us, or our parents, completely out. On the web site www.ehealthinsurance.com there are policies available with high deductibles (the amount you would pay) but beyond the deductible, the coverage is extensive with low premiums in the $20-$30 per month range.

For older employees with families, this approach is a good alternative for covering dependents in situations where the employer does not pay for dependent coverage at the prohibitive rates of the company group health plan. With insurance rates increasing by 25% or more, this may be a good time to evaluate this option.

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. Don't get me started on the costs of bottled water, coffee at $1.50 per cup, $8 movies and all the other opportunities to spend unnecessary amounts adding up to $500 per month or more. Writing down every dime spent is one of the first defensive moves against runaway spending habits. Learn how to create and stick to a budget. Money is a way to store energy. If you understand it, spend it wisely and save it up, the day will come when you can use that "energy" in place of having to work for a living.

Mutual funds may differ from equity securities in investment objectives, liquidity and diversification, and tax consequence. Please check with your accountant regarding your specific tax consequences.

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.