There is a long standing understanding that a penny saved is a penny earned. I submit that the statement is false. Here’s why:
When you save a penny by substituting out cheaper alternatives, using coupons, or other means, you become one penny richer.
When you earn a penny, it must enter a pool of tax piranhas before you can take a fraction of it home.
Let’s start at the Federal Income Tax
When looking up my effective tax rate of 2% on my federal tax return, I really don’t feel that bad about taxes. To make me even happier, it has been going down every year since we were at 7% in 2013 (before we had 3 babies).
Since we are talking about the marginal level, we will ignore the effective tax and look only at the tax on that last penny earned. For most Americans, this is a 15% tax ($18,550-$75,300 taxable income for 2016).`
Social Security & Medicare Tax
Also taxed at the federal level and collected by the IRA are the Social Security Tax (6.2%) and the Medicare Tax (1.45%). This is a flat tax with no brackets or caps until $118,000. These taxes are in addition to the federal income tax and neither one is deductible from the other. The vast majority of Americans pay the sum total of a 7.65% tax towards these funds.
State Income Taxes
Each state has its own income tax and tax brackets ranging from 0-13.3%. I’m going to use California as an example. The average Californian household income was about $64,500 in 2015 (source), If they don’t have a $4,522 worth of deductions, that puts them in a 6% tax bracket ($59,978-$83,258).
Running Total: 28.65% tax
Unfortunately, that’s not the end of the story…
Yup, we have those too. It turns out businesses must also pay additional Social Security and Medicare taxes when they pay you. Your employer sends off both portions before you see any money. Although one is “paid by company”, the company sends both portions out of your wage by simply paying you less. This adds another 7.65% tax, bringing you up to a running total of a 36.3% tax.
Corporations also pay an”income” tax. Economists debate as to how much of that tax is actually transferred to the workers and how much is “paid” by the share holders, but 20% of the 15%-35% tax is a pretty good estimate (source). Because I have no clue how to estimate how much earnings per employee is a good estimate, I’m going to leave off this tax in my numbers.
A Penny saved is 1.57 Pennies earned
With a tax of 36.3%, you would have to work the equivalent of a 1.57 cent wage to take home 1 penny.
$0.0157 * (1-0.363) = $0.01
There you have it, while earning extra money is really nice, much of it disappears long before you see it. Dollar for dollar, saving is a more powerful tool.
Obviously, there is a limit to this method. There is only so much money you can save and infinite money you can earn. It is also true that there is infinite money you can want to spend. You can have a million dollar salary and still be broke. It is also important to note that saving money isn’t really saving money if it leads to a more costly alternative. Ignoring the oil changes and being forced to buy a new engine, is obviously a bad idea. Where to focus your efforts, depends on where you are on your financial journey.
See how the government taxes your savings as well.
Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.