First of all, check out this quotation:
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
Now, let me ask you this…How do you identify the things you know for sure that just ain’t so?
It’s a tough task, and for good reason, we don’t know what facts to start with.
As a financial planner, I often find myself in a situation where a client shares with me something they’re convinced is true.
To them, their statement is an absolute fact.
For someone else like myself, that same statement may be completely false.
In this post, I’m going to share with you four personal finance facts I feel we constantly get wrong. First, let’s talk about why it’s not a bad idea for you to loan the Government money.
1 – A Big Tax Return Is A Bad Idea
It’s not a myth that having a large tax refund is like giving the Government an interest-free loan.
What is a myth is that this a terrible idea?
For starters, interest rates on savings accounts are extremely low.
Let’s say you have a $5,000 refund. At a 1% interest rate, that’s less than $50 of interest a year (Remember, you’re not depositing $5,000 at the start of the year).
Second, if you prefer to owe money at tax time, there’s a risk you may not have it sitting in your checking account. Owing money to the IRS comes with a lot of downsides.
What’s the benefit of having a tax refund?
An unexpected lump sum of cash is a nice problem to have. Put this money towards your #1 financial priority and you give yourself a big win.
2 – Your Tax Bracket Is Your Tax Rate
There’s a common misconception about income taxes, which is your tax bracket is your tax rate.
Let’s look at the 2017 tax brackets for a single individual.
10% – $0 to $9,325
15% – $9,326 to $37,950
25% – $37,951 to $91,900
28% – $91,901 to $191,650
33% – $191,651 to $416,700
35% – $416,701 to $418,400
39.6% – $418,400+
The common mistake is that a person who makes say $92,000 is taxed on all income at 28%. It would then be true that this person would have been wise to make only $91,900 and get taxed at 25%.
But this isn’t how taxes work.
A person who makes $92,000 is taxed incrementally on their income.
The first $9,325 this person earns is taxed at 10%. They pay 15% taxes on the amount between $9,326 and $37,950. They pay 25% taxes on the amount between $37,951 and $91,900.
They then pay 28% on the amount between $91,900 and $92,000. So, only $28 more.
Increasing your income doesn’t mean you’ll have to pay more tax on all of that increase.
3 – Roth IRA Withdrawal Rules
Waiting to start a Roth IRA until you build a bigger emergency fund? You’ll be happy to know you can withdraw contributions to Roth IRAs anytime, tax and penalty free. This can give you a much-needed head start on saving.
There are a few caveats to using a Roth IRA as your emergency fund:
- It’s important you adjust your risk tolerance. You may want to treat this money like your emergency fund and keep it in all cash.
- A Roth IRA isn’t the account to put your last dollar. Have at least one month’s savings and your high-interest debt paid off before you consider this an option.
There’s a $5,500 annual limit ($6,500 for those over 50 years of age) on contributions to a Roth IRA. So, each year you forego contributions, you decrease your lifetime contribution limit.
It may take you months or years to build up a full emergency fund. Allocating some of that money to a Roth IRA gives you a head start on investing, with little risk.
4 – I’m Throwing Money Away On Rent
It’s true that money paid towards rent doesn’t build equity.
It’s a myth that this is a bad idea.
There’s a lot of number crunching one can get into here.
At the end, renting makes sense for some, as does owning a home.
Here are a few things to keep in mind, which are often overlooked:
- How long do you plan to stay? For the first few years of your mortgage, you’re paying mostly interest and not paying down principle.
- How much do you like your job and how safe is it? If you buy a home, you may lock yourself into one job market.
- Your willingness and skill level to perform maintenance and repairs.
- Will the deduction for interest and property taxes be larger than the standard deduction?
- What is the opportunity cost of the 20% down payment? Can that money be better utilized elsewhere?
If there’s a big takeaway, know that owning isn’t always better than renting.
Now It’s Your Turn
I’d like to hear what you have to say. Is there any misconception you constantly come across?
Or maybe you have a story about receiving bad advice.
Either way, let me know by leaving a comment below.
About the author: R.J. Weiss is a CFP™ and founder of the blog The Ways To Wealth. Visit his blog today for actionable, proven personal finance tips and strategies.
In regards to #1. Oh please, are you saying if you saw $50 laying on the ground you wouldn’t pick it up? Getting a $5000 tax return might only “cost” me $50 because I am only getting 1%, but that $50 is better in my bank account then the governments.
Anyone who thinks it’s better to give a small % of their savings every paycheck so they can get it all back as a lump sum with no interest a year latter, please write me. I’ll be more then happy to take your money, put it into my own bank account and give it back to you later with no interest earned.
Interesting comment. So the idea goes along with human psychology. why do we ask others to pay off smallest debt first? It’s mathematically wrong but has maximum psychological effect. Same way a money that you can’t see coming to your bank account or not at all visible to you, can’t be spent. Mathematically it makes sense to put the money and earn 1% interest, you are right. But not for ones who have weaker control and larger impulses.
RJ Weiss says
To add to what SB says regarding the psychological component…
…It’s important to think how likely that $5,000 will be there by year-end. Not spending the money, may require hundreds of tiny, good decisions throughout the year.
With one lump sum, you may just need to make one good decision.