Who should be saving and investing?

I had planned to address the fallacy (yes, I spelled it wrong last week) of inflation and the silent theft of your savings by the Fed this week, but a discussion I had at lunch yesterday presented an issue that I find more pressing and a sort of precursor to the inflation discussion. So I’ll push off the inflation discussion for another week.

Yesterday, I had lunch with two coworkers that I respect and admire. The topic of discussion was investing, as it often is with me. Eventually we started to discuss who in society should be investing. My belief is that everyone should be saving and investing.

(As a side note, this does not mean that I think the government should make a law to force saving or investing. There are very few situations where I think government regulation is needed and to be honest I cannot think of any right now. People should be allowed to make and learn from their own mistakes.)

The contrary belief was then voiced that some people could not afford to save or invest. This was followed up with an anecdotal example of some specific people not being able to buy groceries when their paychecks were temporarily interrupted and arrived a week late.

Who’s Fault Is It?

I know this makes me sound like a jerk to the majority of the public, but if a person cannot pay for groceries after a week’s interruption in income, then in my opinion that is that person’s fault alone. That is not the fault of anyone outside that person. That is the fault of the person for not saving and creating a cushion that they can fall back on when times are not as fat as they are on that day.

But if these people can’t even buy groceries after a week’s interruption in income, then they just do not have any extra money to save, right? In my opinion, this is the same as saying that it is okay for a person to steal something just because they want it. It is an excuse. In fact, I would venture to say that by not saving, a person is in fact stealing from their future self. History is pretty consistent in showing that times will not always be as good as they are at any given point. So if a person is not saving, then eventually history will repeat and that person will not be able to sustain their standard of living.

So now the question becomes how can that person save if they have no room in the budget to do so? Well, in my opinion, the assumptions of the problem are false. The person can save. How do I know it? I have the spreadsheet to prove it. I don’t agree with a minimum wage, but it makes this particular discussion a bit easier because I can start with that as the smallest amount of income that a person can have.

Running the Numbers

The minimum wage right now is $5.15 per hour. So at 40 hours per week, and 50 weeks a year (2 weeks given for sick leave or vacation), a person can bring in a gross income of $10,300. Last year, the personal deduction was $5,150, which leaves them with $5,150 in taxable income. The tax rate last year on that much income is 10%, so they would at the most owe $515 in income taxes. But they also owe FICA on the full amount at 7.5%, which is another $772.50 in taxes. So total out of their earned $10,300, this person has $9,012.50 to spend.

In my area, a room can be rented for $275. This would be a room in a 3 bedroom house with 2 other roommates, but it would be a private room. It also includes a washer and dryer. Then utilities of electricity, water, and trash would cost about $32. Food and groceries for one person per month can easily be kept at $125. I’ll give a $50 allowance for transportation, but I think that is high, as I see people walking to work at Wal-Mart on a daily basis. These are all of the normal monthly expenses that a person needs to survive and maintain employment. The sum total comes to $482 per month, which is $5,784 per year.

So this person has $9,012.50 in income and $5,784 in expenses, so they should be able to save $3,228.50 after tax. So they could save more than 30% of their gross income per year. You might also note that in one year they saved more than 6 months of expenses. So now if this person lost their job or got sick or hurt so they couldn’t work, or even had a temporary interruption in their income, then they have the money to sustain themselves until they get over that hump.

The argument at this point generally becomes, that an existence on $5,784 per year is not living. I beg to differ. What you are really saying is that you don’t want to give up such and such creature comfort. But in reality one can entertain oneself in many ways. Parks are free. The library is free (and it has books, DVDs, tapes, and computers for internet use). And friends are free. And I hesitate to say it, but local TV is free (if you don’t count the rotting it causes in your brain or the loss of time that you could be spending investing in your knowledge).

Yes, there are other more expensive interests to pursue, but until a person can afford those pursuits in both fat and lean times, my opinion is that person should abstain. One of the hardest things to do is to lower one’s standard of living, so the logical conclusion is that one should not prematurely raise one’s standard of living until one is certain that the new standard can be maintained.

Investing Is Also Necessary

Although I am planning to show that inflation is a fallacy and actually theft by the Fed in a later post, we still have to deal with it because it has a real detrimental effect on our savings. So even though one is now saving, one cannot just save. One has to invest to maintain and improve their level of savings to stay ahead of inflation.

Of course a further benefit of investing is that eventually your investments could replace your current income and even allow you to increase your standard of living.

It is important to note that without savings one can’t invest at all. Investing, simply put, is expending something of value now with the hope of creating more value later. It is the “hope” part of that statement that requires savings for investing because hope implies uncertainty. Thus, there is the possibility that one will not receive back all of the investment. And if one absolutely needs that money for survival, then one can’t risk losing it on an investment, therefore one can’t invest.

Conclusion

So to put it simply, everyone should be saving and investing. If they are not, then they are living beyond a maintainable standard of living. They will have no cushion when something bad comes along and only themselves to blame.

But if they do hit hard times, we as a society should not bail them out. It will only encourage them to do it again, and not teach them the lesson that they should be learning about the importance of saving. We’re about to do it with the sub-prime mortgages, but these are the epitome of people that are living beyond a maintainable standard of living, and they definitely need to learn this lesson.

Responses

If you disagree with the opinions in this article, write in or leave a comment to let us know why. We’d also be curious to know how many of our users out there are regularly saving 30% of their income since we have shown that even the lowest paid workers can do it.

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Which is better, Traditional 401k or Roth 401k?

Inflatable Dividends

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Traditional 401k vs. Roth 401k

I was asked not too long ago which retirement account, Roth or non-Roth, is better to contribute to. My knee-jerk reaction was to say the Roth because I don’t like paying taxes. But really that wasn’t a fair answer because it was completely based on emotion and not facts. And emotion and investing do not mix well. So I resolved to create a spreadsheet to prove my point and show conclusively which type of account is better. (Turns out my gut emotional reaction was wrong.)

To cut to the conclusion for any that don’t care about the particulars, if you assume that your after tax spendable income now will be roughly the same as your after tax spendable income in retirement, then you want to go with the regular 401k because you will end up with about 10% more years of retirement income over the Roth 401k. The reason is that when you put $30k into a regular 401k versus $30k into a Roth 401k, you end up with more spending money in the non-Roth situation. So to make the two situations equal, and end up with the same amount of spending money, you have to take that extra and invest it in a taxable account.

This finding of the regular 401k being better only holds true if the tax rates in the future stay below 30% for earned income and 47% for capital gains. If they go above those rates then the Roth 401k becomes the better option. (Although, what it really means is that the government is taxing away your retirement money because the Roth 401k doesn’t change, its just that the Traditional 401k gets worse.)

To help with your decision on whether or not earned income tax rates will go that high take a look at the following link.

http://www.moneychimp.com/features/tax_brackets.htm

You’ll notice that for the last 7 years the 15% tax rate stays at about the same standard of living after inflation. But I’m not prepared to believe that congress and the fed will keep their hands out of my pockets, so I’m investing in my 401k and in my Roth IRA in case tax rates do rise. That way I’ll have the option when the time comes. (I’ll address the fallacy of inflation and the silent theft of your savings by the Fed in a later rant.)

For those of you that are interested in the particulars and that want to check my work, below is the spreadsheet that details my calculations along with an explanation of the columns and lines. (This spreadsheet will open in Microsoft Excel, but you may need to resize the columns to see the numbers correctly.)

401k vs. Roth Spreadsheet

– Column B is money invested in a regular 401k.
– Column C is the extra money from the regular 401k tax savings invested in a taxable account to match the same spendable income as the other columns.
– Column E is money invested in a taxable account using a strategy that requires annual buying and selling (this was to show the effects of paying taxes every year).
– Column F is a taxable account using a buy and hold strategy.
– Column G is a Roth 401k.
– Line 2 is an assumed amount of $100k income. Changing this number would affect the tax calculations.
– Line 3 is the FICA tax which you pay no matter what on earned income (up to a point) so it doesn’t really matter for this expirement.
– Line 4 is the deposit of $30k to the regular 401k. Again this amount is just assumed, it could be more or less.
– Line 5 is your resulting taxable income at that point.
– Line 6 is your income taxes. This is where things would change if you had a higher or lower income. The equation used assumes that you are in the current 25% tax bracket, given the $100k income.
– Line 7 is your income after the taxes are taken out. (Sorry you had to see that. Painful, I know.)
– Line 8 is the deposit of $30k to the Roth 401k.
– Line 9 is the income remaining after the Roth 401k deposit.
– Line 10 is the amount that has to be placed in a taxable account to make all of the columns match in spendable income. Here is where the 401k gets an extra $7500 that the Roth column paid to taxes.
– Line 11 is the amount of spendable income left after the investments are made. Notice that it is equal so we are now comparing apples to apples. Meaning you will have the same standard of living now for all columns.
– Line 13 is the return earned each year on the investments. This number really doesn’t matter. The answer comes out the same for the Roth vs non-Roth 401k even if it is zero or for that matter negative.
– Line 15 through 45 are the years of returns. I have separated out the taxable and non-taxable parts of the non-Roth 401k into columns B and C with C being the taxable account. Again the amount of time (30 years) doesn’t affect the outcome, it could be zero years or 100.
– Line 47 is the total savings and earnings after the 30 years of investment.
– Line 49 is the top tax rate paid on earned income in retirement. If this number goes higher than 30% or you have a higher income in retirement than in your working years, I expect that this will change the outcome.
– Line 50 is the top tax rate paid on capital gains in retirement. If this number goes higher than 47% or again if you plan a higher retirement income than in your working years, the Roth might be the better option.
– Line 52 is the amount of income desired in retirement. Notice that this is the same across all columns to again continue comparing apples to apples.
– Line 53 is the amount you will need to withdraw from this account to end up after taxes with $40k of spendable income in retirement.
– Line 54 is the taxes you will pay on the amount withdrawn. (Notice Column E doesn’t have taxes because they were already withdrawn for the year on Line 45.)
– Line 55 is the check to make sure we calculated the taxes correctly and that all columns still match in spendable income.
– Line 57 is the number of years (assuming no more growth) that you could live on the money. For me this is the best method of comparison. Note that cell B57 is the sum of the number of years for the 401k and the taxable account that is paired with it.
– Line 58 is the percent more financially free life over the buy and sell option.

Again the calculations bear out that the regular 401k is the better option in the current tax environment. But the Roth 401k is not too far behind depending on tax law changes in the future or if you decide to have a higher income in retirement, so it might be prudent to put money into both types of accounts.