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Home for the Holidays and a Talk About Money By Stephen J. Butler

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This annual column is the widely-regarded "ice-breaker" which can lead to a wonderful parent-child conversation about money. In a "home for the holidays" spirit, we enjoy a heady mix of generations whose experience, financial knowledge and levels of entitlement can all differ substantially. Coincidentally, this is a week when we typically review our annual budgets and make our New Year's resolutions.

Katherine Graham, who ran the Washington Post newspapers for forty years, has written an autobiography about her amazing life as a businesswoman. She tells the story about how, at an airport once, her friend Warren Buffett (the richest guy in America at the time) went to get change for a quarter so he could use a dime for the telephone and save fifteen cents. Managing money effectively begins with the truism: "when you watch the dimes, the dollars take care of themselves." Good money management starts with an appreciation for the role it plays in leading a successful and fulfilling life. In the end, it's not how much you make, necessarily, but how well you manage what you have.

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

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) is 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. 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.

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%.

When we contribute to 401(k)s or IRAs, we remove from taxable income calculations 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 income for tax calculation purposes because mortgage interest and property taxes are tax deductible. Rent is not. Whenever we say that something is "tax deductible," it means that we are paying for it with tax-free dollars. This means that a portion of that expense is funded with money that would otherwise have disappeared in taxes. It's the same net effect as receiving a government subsidy.

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 $100,000 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. It builds to $140,000 in about eight years or about as much time as you have spent in high school and college. 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.

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. If you want to be "pro-active," choose funds that have low annual expenses and no commissions.

The past few years have been depressing for novice investors. Relax. Pray that the market plummets even further. When you invest regularly each pay period you are dollar-cost averaging. This mechanism keeps us buying stocks automatically at bargain prices during the downturn. It ensures that we will be "buying low and selling high." --- eventually.

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. Using a retirement plan to save will generate about fifty percent more money (thanks to just the tax savings) than any conventional after-tax savings program.

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. 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 and with low premiums in the $20-$30 per month range.

Always remember Warren Buffett and his effort to save 15 cents. 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, deli lunches and all the other opportunities to spend unnecessary amounts adding up to $500 per month or more. Saving $10 per day adds up to $3,650 AFTER-TAX dollars per year. This allows us to afford about a $5,000 PRE-TAX 401(k) contribution which could accumulate to $100,000 in just about ten years. 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" to create flexibility and a living that will hardly seem like "work."

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results. Periodic Investment Plans, Dollar-cost averaging and Compounding do not assure a profit and do not protect against losses in declining markets and you should consider your financial ability to continue to purchase through periods of low price levels.