I am impressed by the duality of our universe. The same paint on the wall looks a different shade from different angles; an identical sandwich seems to taste different from one day to the next depending on my mood; the same song evokes totally different filling in me depending on whether I am listening to it in the morning or the afternoon. Vision is the ability to interpret what you see, and that is a matter of perspective.
As you become more familiar with the world of money and finance you will begin to recognize the reality that most concepts exist in this state of duality. This is true of the concepts of income, credit, debt, and expenses. It would be nice if all things were what they appear to be. But this is simply not the case, and your financial success is directly proportional to your ability see that which is not obvious.
As you know, lack of knowledge in general can be very expensive. But in the context of expenses it is doubly so. For instance, there is a relationship between income and expenses which rarely receives any consideration. Did you know that when you spend money, it is after tax money you are spending, and as such your expenses are actually costing you considerably more than you think? Here is a good example of what I mean:
Suppose you decide that you need a new car, so you trade in the old car which you have already paid off for a newer model. Sounds great, right? You’re looking fine driving around town in your new wheels. Here’s the catch. Your beautiful new car comes with a $600 monthly payment. You have increased your annual expenses by $600 x 12 months = $7,200. But do you realize that this $7,200 is after-tax money, meaning that you will have had to earn it, and then pay taxes on it, and only then could you spend it on your car? If your effective tax rate is around 30% of your gross income (in other words, your total tax burden equals to 30% of your gross pay), then you will have had to earn $10,285.71 in order to pay the taxes and then have $7,200 left for your car payment. You might as well stop kidding yourself that your car only costs you $600 per month, because $10,285.71 per year is actually an $857.14 monthly car payment.
Does it seem logical that someone earning a pre-tax annual salary of $50,000, would spend $10,285.71 of it on a car? This person brings home a paycheck of about $3,000, and spends 20% of it on a car. That’s one fifth of his take-home pay. That’s one dollar out of five going for a car!!! Is this something you would do?
Not me! When our twins were born, Patrisha and I purchased a ten year-old minivan for $1,000. Believe me when I tell you that we could have afforded a $600 monthly payment. But then again, $600 per month for 60 months is $36,000, which invested at a compounded rate of return of 12% for 18 years would become roughly $275,000. Not to mention that $600/month is an interest payment on $120,000 mortgage at 6%, which buys a property capable of generating $500 to $900 per month of cash flow. Are you starting to see what I mean about financial literacy and about reading numbers?
Paper Losses
The duality I spoke of earlier manifests itself in that expenses are not created equal. Some expenses, just as the above discussion suggests, are actual expenditures, things that cost you money. Those are BAD expenses, and if you have too many of those you will go broke. But as you might have guessed, there is such thing as a GOOD expense. A good expense does not cost you money; it actually saves you money. This is because while good expenses are not actual expenditures, they appear that way on your Financial Statement and have the effect of off-setting certain income, which can substantially lower your effective tax rate.
Good expenses are referred to as paper losses, or deductions. Unfortunately, there are precious few opportunities for employees generating W2 income to benefit from these paper losses. Paper losses are almost exclusively the domain of passive and portfolio income, which belong on the sphere of business and investing. Here is an example of how paper losses work:
Let’s say that you own a $100,000 investment which yields $10,000 annually. If it were necessary for you to pay a 20% tax rate on the entire $10,000 yield, then the amount lost to tax would be $2,000, bringing the ROI (Return on Investment) down to $8,000, which is 8%.
But let’s assume that you benefit from $9,000 of paper losses due to certain deductions available to you with regard to this investment. Remember, these deductions appear as losses without having actually cost you anything. In this case, since in the world of business and investment only the net profits are subject to income tax, the taxable portion of the yield would be $10,000 – $1,000 = $1,000. Your tax expense at the rate of 20% on $1,000 amounts to a mere $200, leaving you with the net ROI of $10,000 – $200 = $9,800, which is 9.8%. The good expenses have saved you $1,800 off your tax bill. This is real money that can remain in your checking account. Paper losses are very helpful, indeed! And this is just one investment generating a $10,000 yield. Imagine you have 10 of these; the tax savings could potentially add up to $18,000 per year!
So you see, not only do bad expenses cost more than people think, but good expenses (paper losses) are capable of saving a lot of money for people who know about them. This is why while I work very hard at limiting my bad expenses, I also work very hard at expanding paper losses, some examples of which are interest right-offs, depreciation of equipment and property, mileage, and many more. Ask a good CPA to help you understand all of the available to you options relative to paper losses.