Save First, Pay Taxes Later
by David Bach
Most people pay everyone else first -- taxman, landlord, credit-card company, and so on. They try and budget every week, month, and year hoping that if they're careful they'll have some money left over.
This is absolutely, positively backwards. And because of it over 70 percent of Americans continue to live paycheck to paycheck regardless of increasing incomes. We make more. We spend more. And at the end of the day we're still broke. Are you tired of this game?
"Pay yourself first" means just what it says: When you earn a dollar, the first person you pay is you. Sounds simple, but most people don't do it.
Instead, the first person they pay is Uncle Sam. They earn a dollar and before they even see it, they pay around 20 to 30 cents in federal income tax. Depending on the state they live in, they may pay another 5 cents in state income tax. On top of that, there's Social Security, Medicaid, and unemployment. In the end, the government gets as much as 35 to 40 cents of their hard-earned dollars.
The Taxman Gets Smart
The government didn't always get first dibs on our paychecks. Before 1943, folks got their hard-earned paychecks first and paid taxes later. There was a problem with this system, however: People weren't saving enough money to pay their taxes. They spent what they earned and when it came time to pay taxes they didn't have the money.
So the government created a system under which it got paid automatically every time we got paid. And that system has worked for the government for over 60 years. But how is it working for you?
My point here is not to have you break the law, but rather learn from the government.
You have a right to legally avoid federal and state taxes on the money you earn. You can legally pay yourself first by simply using a retirement account. There are many different types, including 401(k) and 403(b) plans, IRAs and SEP IRAs. The one thing that makes all of these "pay yourself first" accounts is that the money you put in them is either pre-tax or tax deductible.
$14 a Day Could Grow Into a Cool Million
The most common question I get asked is, "How much should I save?" Your goal should be to save one hour a day of your income.
If you start this week by having one hour a day of your income deposited into a 401(k) plan at work, you will be in fantastic shape. If your employer doesn't offer a retirement account, go to a bank or brokerage firm (on- or offline) and set one up.
Let's assume you make $50,000 a year. That's about $2,000 every two weeks, which is how most people are paid. So to save 10 percent of your income, which is less then an hour a day of savings, you'd have to save $200 every two weeks -- or $14 a day.
If you invested $200 every two weeks for 35 years in a retirement account that earned an annual return of 10 percent what would you have? Quite a pot of gold: $1,678,293.78.
Depending on how you calculate this and compound the interest it could be higher or lower, so don't waste time debating the calculation. The point is you can make a lot by setting up a retirement account that pays you before Uncle Sam takes his cut.