Here is a great way to think about the money you spend.
What It Really Costs Matt Trogdon | Oct 12, 2021
A LOT OF INK HAS been spilled over young people’s spending decisions and the impact on retirement savings. Whether it’s a latte or a lunch out, the thinking goes, we all spend money on daily trifles that rob us of a much greater sum in the future. Back in 2019, Suze Orman made headlines when she likened a daily takeout coffee habit to “peeing $1 million down the drain.” I’m sympathetic to this line of thinking, which is based on solid time value of money principles.
For financial planning enthusiasts like me, time value of money calculations can be a lot of fun. I recall getting my first financial calculator at age 34, which I promptly employed to badger my little cousins. Every time they bought something, I told them how much that money would be worth if they just invested it for 30 years and earned a 10% compounded rate of return. They rolled their eyes and tuned me out. Turns out it’s hard to get 20-somethings to think about their lives 40 years in the future. Go figure.
But there might be a better way to talk about spending decisions that makes them feel more tangible, no matter how old we are: by talking about the pretax cost of our purchases. We make purchases with after-tax money. That’s true whether we’re buying breakfasts, taking trips or making mortgage payments.
To afford anything we buy, we actually need to earn more money than the sticker price shows. For example, if we pay 30% in federal and state income taxes combined, a $2 coffee costs $2.86 in pretax income, a $10 lunch costs $14.29, and a $50 night on the town costs $71.43.
Once we understand that lesson, we can better compare our spending costs with our pretax income. That’s helpful for those of us who are salaried workers. If you’re like me, you can rattle off your salary without thinking about it, but it’s harder to remember your take-home pay.
Another advantage to this approach: It deals with the reality of current earnings, rather than the distant future. That can be especially helpful for younger workers. A 23-year-old working his first job will likely have a better grasp of the money he’s making today than of his potential net worth in 30 or 40 years.
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One of the first things we are taught in business school (well, at least the school I attended), was to tax-effect everthing. So, for example, for a firm that was earning profits, the cost of supplies wasn’t the nominal dollar amount we paid. On the other hand, in years when we were not earning a profit, the costs added to losses which we then adjusted for/discounted the value of the tax deductions.
For decades, I attempted to have my employer adjust the pay advice to confirm the impact of pre-tax contributions – showing how each paycheck would have been higher, but for the cafeteria plan, 401k plan and later IRC 132 transportation fringe benefit provisions. Never succeeded.
Then I tried to focus attention on the annual total rewards statement. Failed again to use that statement to demonstrate the impact.
And, I doubt many heard my counsel when I noted that deferring income from active service to retirement, whether as a 401k contribution or an HSAs contribution offered hidden value in terms of control over timing – where even something as simple as relocation to a state with a lower income tax rate (or no income tax rate) might increase the value an individual ultimately received.
This story only has value if you can show how a person can spend the pre-tax dollar, avoiding the taxes.