Suppose you make $120,000 a year.
Just to be perfectly clear, this is a fantastic sum of money anywhere in the world. Even here in Silicon Valley. Though it is becoming increasingly typical, as it is the average salary of an engineer, most of us would be thrilled to be making that amount.
I selected $120k primarily because the math that follows will be more convenient to explain: it breaks down to $10k in gross income per month.
And yet, $120k doesn’t seem like it’s enough. Why is that? That’s because it’s not really $120k, and we should stop thinking that it is.
The reality is that we overestimate how much income we actually make, and we underestimate the actual cost of our spending.
This would seem as though we are deliberately deluding ourselves about money. That might be partially true, but I don’t think that is the main reason. The primary culprit has more to do with how we as a society have come to think and talk about money.
For example, you probably are already well aware that what matters to long-term financial goals is the amount you actually take home and keep, not the headline gross compensation number. But that does not mean we regularly think about our finances in those terms. In fact, I suspect that if I were to ask you how much you made, your first thought would almost certainly be your gross salary, and you probably would not have a clue about your take-home amount. Depending on how long you have been working, you have probably grown accustomed to the surprisingly meager amounts that actually get deposited to your bank account periodically. You might be vaguely aware that there are significant automatic paycheck deductions that are responsible for this, but you might not fully understand the details.
The Income Side
Let’s break it down, assuming you’re a single person living in California with no allowances making $120k in 2015 and paid monthly, using the salary paycheck calculator from ADP:
- Monthly Gross Income: $10,000 ($120,000 annually)
- Federal Tax: $2,169
- Social Security: $620
- Medicare: $145
- California Tax: $761
- CA SDI: $90
- Monthly Net Pay (After Taxes): $6,215 ($74,580 annually)
We’re only looking at the government-related stuff, and we’re already at ~38% taken off of gross income.
Federal Tax: This is pretty self-explanatory. The one item of note is that the income tax bracket tiers are adjusted every year. For this example at $120k, we would be in the 28% income tax bracket, which affects income above $90,750 to $189,300. The 28% tax rate would be applied on the incremental dollar. The blended tax rate per the calculator is ~21.7%, which reflects the lower tax rates that are applied on the first $90,750 in income.
Social Security: This is a 6.2% tax that ostensibly will be used to fund social security payments. Of note is that the tax only applies to a certain wage limit, which rises every year. For 2015, that limit is $118,500, so the maximum tax is $7,347. This tax is quite insidious in the way the wage limit rises every year. As can be seen from that table, it’s practically doubled in the last 20 years. It seems tough for income growth to outpace the growth in the wage limit. This is where our $120k just doesn’t seem to be quite enough – you really need to have a super high income for the FICA rate to become negligible. For most of us, we are all basically paying an extra 6.2% in taxes. It also seems to be a tax that gets overlooked, even though this is such a significant chunk. Obama reduced this tax to 4.2% for 2011 and 2012 as part of the various stimulus programs, but it’s unclear how many people actually noticed. Had the federal tax brackets been reduced by 2%, it likely would have received far more attention.
Medicare: This is basically like social security, but with two differences: (1) the tax rate is 1.45%, and (2) there is no wage limit. In fact, the rate goes up to 2.35% if you have income above $200k thanks to Obamacare. This is likely why there was such an uproar on this tax. For social security, there is at least a limit and maximum tax. For Medicare, there is no limit, so the tax is effectively uncapped. Once you were to make above ~$390k, you would actually pay more in Medicare tax than Social Security tax. Social Security and Medicare are typically referred to together as FICA (Federal Insurance Contributions Act) taxes.
California Tax: Not only do we owe taxes at the federal, we also owe taxes at the state level. By the way, not all states have an income tax. California, in spite of its dire budget issues, still manages to levy pretty high tax rates. What is more, there is no distinction in earned income or investment income in California. All income is taxed at the same rate. In this example, we are at the 9.3% bracket, and a blended rate of 7.6%. The one silver lining is that the taxes owed to California is deductible for federal income tax purposes.
California State Disability Insurance (SDI): Another social program that covers short-term disability income replacement. It’s mechanically similar to Social Security. The tax rate in 2015 is 0.9%, and the wage limit is $104,378, resulting in a maximum tax of $939.40. The rates and limits change year-to-year, but the maximum tax has stayed around $1k per year. The growth in the wage limit has been disconcerting, and it wouldn’t be a surprise to see this continue to go up. As with FICA and Medicare, this doesn’t seem to get the attention that the income tax rates enjoy.
That covers the primary government deductions. There are plenty of caveats to the above, of course, as the amounts will change depending on your ability to claim allowances, whether you have investment income versus earned income, and whether you have ways to reduce your amount of taxable income. It’s a lot of detail that won’t be covered. The complexities and unique situations are why most articles will focus on the federal tax brackets as that applies to everyone.
I think the key takeaway is to not underestimate the amount of taxes owed to the other categories. In this example, these taxes in aggregate ($1,616) are almost as much as the federal taxes ($2,169).
And still, we’re not quite done yet. This is not the amount that gets deposited into the bank account. There are plenty of other categories of paycheck deductions, but at least these will generally be within our control and be contributions to our benefit. Some of these include:
Retirement Savings: 401k contributions are the primary example, and they have the added benefit of being tax deductible. But not for the FICA taxes. Did I mention how insidious these taxes are?
Investments: Some companies offer employee stock purchase plans (sometimes at a discount), but require employees to take paycheck deductions in order to participate.
Benefits: The costs of health care insurance and any other benefits payments will be deducted here. Depending on how generous your company is and how much coverage you need, these payments can be quite significant.
Free Money: Not everything is a cost, but you may need to opt-in to take advantage of this. This might include employer matching of contributions to 401k accounts or HSA accounts, or discounts of stock purchases. This is basically free money for the taking.
So after all of that, what are we actually taking home in this example? Unfortunately, I haven’t found a good calculator that can accommodate all of the different categories. The following presents the details including the maximum 401k contribution.
- Monthly Gross Income: $10,000 ($120,000 annually)
- Federal Tax: $1,749
- Social Security: $620
- Medicare: $145
- California Tax: $607
- CA SDI: $90
- Monthly Net Pay (After Taxes): $6,789 ($81,468 annually)
- 401k: $1,500 (pre-tax contribution)
- Benefits: $500 (estimate)
- Monthly Take Home Pay (After Taxes): $4,789 ($57,468 annually)
The complication is that the amounts contributed to the 401k and to benefits are generally pre-tax dollars and would impact the amount of federal and state taxes owed. It’s tricky to factor the benefits cost in since this varies widely by employer. I assumed an estimated benefits cost of $500 per month after-tax in this example.
Note that the inclusion of the 401k contribution reduced the overall taxes owed significantly, by close to $7k. It took the implied overall blended tax rate from 38% down to 32%.
Note also that our take home pay of $4,789 per month is now less than 50% of the overall gross pay.
I would consider this amount to be the true income, rather than gross income. Although the 401k and benefits costs are both technically discretionary, I think both of these categories are mandatory expenses as a practical matter. Maxing out 401k contributions (or contributing at least 15% of gross income to the 401k) should be considered the minimum. The benefits portion can even be considered as a kind of tax as well. Although there is some flexibility as far as the level of coverage selected, most of us are likely stuck with whatever our employer offers us. And although we could technically opt out of benefits coverage, that’s just very unlikely to happen.
Where does that leave us as far as how to think about how much we actually make? It is a complex question. I think the best we can do is come up with ranges as a percentage of total gross income:
- Net pay after taxes: 65% to 70%
- Monthly take home pay: 45% to 50%
- Disposable income after savings contributions: 35% to 40%
The savings contribution assumes that you save 10% of gross income, which seems to be the default retirement advice. That advice would typically include amounts contributed to a 401k, but we’re aiming for an early retirement. If we want to do that, what’s leftover just isn’t very much.
The point is that we need to move off the anchor of gross income ($10k per month), and we need to recognize that our income is in reality only about 40% of that ($4k per month). That is, we need to budget our lives based on the $4k as the reality and disregard the $10k as merely fantasy. It might seem like a small step, but when the average rent in Silicon Valley will easily consumer your entire income, it might help to put things in the proper perspective when making significant decisions. We just need to realize that we make much less than we think we do.
It would be hard enough if that were all there was to it. Unfortunately, we also tend to think that expenses are much less than they actually are.
We’ll examine the implications on the spending side in a future post.