Maximizing After-Tax Dollars Smartly! (Part 1)

Wealth-Building MathPersonal BudgetingSave Taxes

Jun 13

Image sourced by The New York Public Library @nypl

Over the weekend, Ralph, a longtime Budget and Grow Rich® fan, emailed us, asking us to write about the difference between pretax income and after-tax income and as some people call it, pretax money and after-tax money. So, let’s get to it.

At the end of the day, I’m sure you know that in almost all cases, you can spend after-tax dollars, Not pre-tax dollars.

This is important because this exercise factors into building wealth, personal budgeting, understanding how much money you can spend every month and organizing your spending to equal at most your take-home pay.

Let’s look at your salary.

Your employer pays you a salary, let’s say a $100,000 salary per year.

But you can’t spend $100,000.

Because hopefully you’re contributing to your retirement plan – think 401(k), 403(b) or another retirement plan.

And then there is Uncle Sam and his cousins – the IRS, your state government and local government – grab money for income tax payments and the Social Security Administration (Social Security withholdings). They take their pound of flesh.

And in addition, perhaps you pay money towards benefits, for example health insurance, vision care, life insurance and long term disability (LTD).

Needless to say, your $100,000 salary isn’t quite $100,000.

In fact, it’s probably closer to $60,000, 40% less.

Before we share some valuable personal budgeting tips and wealth-building tips, let’s explore one of my favorite financial formulas which helps you analyze pretax money and after-tax money:

Let’s assume that your total tax rate (composite tax rate or effective tax rate) is 40%.

40% is probably a reasonable estimate.

But check with your accountant or tax advisor to get a sense of your effective tax rate.

Suppose you want to accumulate $100 to treat your family to dinner at a nice restaurant.

One way to accumulate the $100 is to reduce your spending in order to free up the $100.

You could work overtime and earn overtime pay.

The question is, “How much money do you have to earn in order to generate $100 in cash. In after-tax dollars?”

The formula:

After-Tax Cash amount divided by (1 minus your tax rate)

In this example, $100 divided by (1 minus 0.40 or 40%) = $100 divided by 0.6 or 60%,

Which equals $166.67.

And to check the match in our wealth-building calculation:

If we have to pay 40% of our pretax income or pretax salary in taxes – income taxes, Social Security withholding, etc. – and. . .
If we earn $166.67 and our tax rate is 40%, we pay 40% of $166.67 in taxes; or $166.67 multiplied by 40%, which equals $66.67.
Therefore, we’re left with $100 in after-tax money – $166.67 pretax salary minus $66.67 equals $100.
There’s the $100.

Suppose your hourly wage equals $50.

Considering that the annual salary in our example is $100,000 and there are 2,000 hours in a work year, the hourly wage equals $50 ($100,000 divided by 2,000 hours).

Following our example, to save $167.67 pretax, at $50 per hour we would have to work 3.35 hours ($167.67 divided by $50 salary per hour).

Instead, assume you cut your expenses and spending this month and you save $75.

Now, you don’t need to earn an extra $167.67 pretax. You need to earn only $92.67. That means you have to work an additional two hours ($92.67 divided by $50 per hour).

Follow these 3 tips to save more money and build wealth:

Structure your expenses and spending so that your total spending is less than your take-home pay.
Reduce your spending and cut out some discretionary spending to create free cash.
When you are running short on cash, reduce your spending. Don’t use your credit cards, especially if you won’t be able to pay off the statement balance in full.

Consider pretax income and after-tax income, pretax money and after-tax money in your financial planning and quest to build wealth.

Once you start considering pretax money and after-tax money and organize your financial affairs to create cash flow, I’m pretty sure you’ll really start creating cash flow, free cash flow and start building wealth.

This strategy has worked for me. It can work for you!

See you next week.

Arthur V.

P.S. To Save More Money Every Day – click here.

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Disclaimer: OH and Please Remember, we are Not financial advisors, financial planners, attorneys or accountants and are Not providing any specific financial, tax or legal advice here. Be sure to conduct your own due diligence and consult your own professional advisors to get sound professional advice that’s specific to your financial and personal circumstances, risk tolerance, time horizon and investment goals and objectives among other key factors!