A while ago I had a discussion with a friend in Chile and he was thinking about moving to the US for a job. He asked about our pay and an issue came up that exemplified the strange way we look at compensation in the US here that we don’t often think about.

When we talk about comparative pay here we often talk about gross income in pre-tax terms. This is common here: I make 60k a year or I make 150k a year gives us a ball park figure on where someone lies on the economic earnings pyramid. However, my friend remarked to me that in Chile they only care about after tax pay and monthly pay. It took a minute for me to break down what these would be from the annual figures I offered but it also got me thinking. Why don’t we look at it that way here? If you think about it, it makes a lot more sense to look at pay in terms of what we make in a month, since all our bills will likely go through one cycle in a month and also to care more about our pay after tax.

The after tax figure is especially one we don’t often enough pay attention to here in the US. If I were offered a hundred thousand dollars a year in gross pay, but after taxes took home sixty thousand and then at the same time offered a job where I would make seventy thousand but pay no taxes, it’s a no brainer that I would take the job paying seventy thousand a year. That’s 10 thousand more in my pocket annually. Remember this part because we will come back to visit it later I the post.

Calculating What You are Worth

If we are being cold hearted economists, we can even break everyone’s pay down into how much that pay is actually worth. That is, based on the pay you receive now, assuming you make that pay forever and adjusting for inflation, how much do you need in savings order to make the same amount after tax from interest and dividends? Many extreme savers calculate their estimated expenses in retirement for the year and have that figure as the goal of what they want to make after taxes from their investments. I want to perform an exercise where we can put a dollar amount on how much each of us would need to save to make the same take home pay as we do from our jobs while also accounting for inflation.

What investment we choose as a savings yardstick is important. We always need balance in terms of our investments because long term we want 2 things. The first is income to support our lifestyle as it is now. The second is to have a portion that grows at least by the level of inflation and maybe even a bit more to account for things like the cost of future health care or particular expenses we have that may outpace inflation.

My proposal for a basic yardstick would be the Vanguard Life Strategy Moderate Growth Fund (VSMGX). This is a fund that has a goal of capital appreciation with a low to moderate level of current income. It is divided into 60% equities and 40% bonds. The fees are low at 0.14% and it is diversified into international as well as domestic stocks and bonds. This is the all in one portfolio I recommend to people if they don’t want to bother with the specifics of investing long term. Vanguard offers 4 different funds of this style, the only difference being that some are tilted towards growth (more equities as a percentage of the portfolio) and some are more targeted towards income (more bonds as a percentage of the portfolio). You can perform this exercise with any of these “Target Risk” funds.

In calculating what one’s estimated worth this way, I will use the following assumptions:

• Use the average return for the last 22 years (the inception of the fund was 22 years ago) which is 7.47%
• Assume that we will create current income by selling shares. Dividends usually get automatically reinvested unless you specify otherwise and you just pay the tax on them at the end of the year. For simplicity we will assume that the sale of shares are taxed at the long term capital gains rate.
• Assume that inflation for the next 40 or so years will be 2.7%, this is currently the level assumed by the social security administration. This will produce real growth of 4.77%
• We will assume that we take out about 3% in real terms in order to meet our income needs, this will allow the portfolio to grow in real terms at 1.77%
• In the example I am going to show you I compare a married couple who’s wages are taxed as income versus if all their income was as capital gains. New York State taxes even long term capital gains the same as wage income so in my example below, I assume there is a huge incentive that one has taken advantage of to move to one of the 7 states with no income tax, mainly Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

Using these assumptions and the current tax brackets for capital gains and income we can see what we would need to save for various income levels in order to have an equivalent take home pay.

The main column I want you to focus on are “Net Income of 3% after Taxes” and the “Gross Income” figure. I just think of how hard some people have to work throughout their careers to make $300 thousand or $450 thousand dollars and then to think there is someone sitting around with $8 or $9 million dollars that could pull in the same type of money if they essentially sat around and did nothing.

The “Needed to Save” column is what the tax system has determined is your value as a worker in my exercise. I look at it as the total lifetime worth of your current earnings. This can be a little depressing to look at. Especially when you consider there are sports stars that are making tens of millions annually for running around a court or a field after all your lifetime of education and hard work.

Taking the Optimistic Path

I just showed above how with a certain amount of money, you can make the equivalent of some really smart people that worked their behinds off their whole life. You can let that get you angry, upset or depressed or you can do what many other people have done: they looked at it as an opportunity.

I want to rehash the table above to show you that not all is lost. A lot of very determined and disciplined people have saved and invested, no matter what their income to reach these levels of wealth and anyone can do it. What I would like to do now is take those same figures and show how many years of saving it would take each income level to save that amount which would provide them an equivalent income after capital gains tax. For this exercise I will use 3 assumptions:

• That in this example our subject puts their money into a more aggressive growth fund. One that gives the long term real return of 6%, This is just below the compound average growth rate of %6.83 for the S&P 500 for the last 100 years calculated by Money Chimp
• I will also assume that this person is a good (but not extreme) saver and saves about 1/3 of her income
• I will assume they continue to make the same pay and it only increases by inflation until they reach their retirement money goal

Every time you read a story about a janitor or lowly or maid who died a multimillionaire this is almost always what they have done. Save and invested consistently over a long period of time and letting compound interest take over from there.

The “Tears to Achieve the Needed to Save Figure” calculates the years of working it would take a person saving this amount that will pay them the same as they have earned for the rest of their lives. The numbers are not too uplifting if you hate your job. They only range from about 26 years to about 29 years.

I want to point out a little column on the far right that I added, and this is where the extreme savers and investors seemed to have found happiness. What if you don’t want to make the same money as you make at your current job? What if you are happy having all the free time you want but making the equivalent of $60 thousand a year? Extreme savers and diligent investors skip over the whole long process, maybe saving 50% or even 70% of their income to get to their retirement more quickly.

If we were to take someone who was able to save more but had the same return and was ok with living off of a $60 thousand income then they could achieve retirement a lot faster, like the below:

There it is, the people you may hear of that retire before 40 or even younger, some even below 30, this was all they did from the get go. They eschewed the spendthrift lifestyle and decided that their personal freedom from a day job was something they valued more than material things. Anyone can do this, the hardest thing is maintaining your discipline and keeping your eyes on the prize. Hopefully this will encourage some of you to start saving and pursuing your own dream of one day being financially free one day.

 

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