Financial Genome Project – Chapter 3

Chapter 3 – Benjamin Franklin the First Tax Planner

“…but in this world nothing can be said to be certain, except death and taxes.” [1]

 ~Benjamin Franklin (1789)

As we discussed in Chapter 2, you are part of a feedback loop that keeps the genome constantly running. We looked at our first connection between you and your employer, and how your salary is sent to your bank account. We showed that if you’re not cognizant of the process, you may be charged bank fees—robbing you of receiving your full salary. Those bank fees are within your control, but there are other genome connections preventing you from receiving your full salary—and those are not really within your control.

Genome – Fee Connection

We left Chapter 2 with our first connection between your employee and you. The picture above is what we’ll call sequencing—a visual representation of the financial genome. The sequence above shows your salary being distributed from your employer, to your bank account, where you can access the money and where you might be charged bank fees. Now, we’ll look into the distribution of your paycheck further to see how payroll taxes, our next genome connection, represent further reductions to your income. The payroll taxes we’ll cover are the Federal/State Income taxes, the Social Security tax, and the Medicare tax. In the first chapters of the financial genome, we’ll stick with the genome in the United States of America. As the popularity of this project grows, we’ll continue exploring other countries, and eventually map out the whole world.

Imagine you’re interviewing for a job and your future boss shows interest in hiring you and offers a $100K salary. You accept the job offer, but your future boss responds, you’ll have to take an immediate 30-40% pay cut. Would you still be interested in this job? Would you be shocked to know that this happens with every job offer in the US?

Payroll taxes have become somewhat transparent in our modern genome. The taxes are automatically deducted from your paycheck and the remainder is deposited to your bank account electronically. Your paycheck stub should show your gross pay less deductions. Your gross pay is the amount before withholdings (taxes and voluntary withholdings), while your net pay is the amount that is actually deposited into your bank account—also known as take-home pay. I remember the difference by thinking about putting a net into a gross pond and your take-home pay is what’s in your net.

You and your employer both pay taxes for your employment—and if self-employed, you pay both sides. You only see your portion on your paycheck. My personal opinion is that people would be more upset about taxes if they saw the full amount. Depending on your state, you may have to pay a State Income tax which goes directly to your state’s government. You also pay a Federal Income tax which goes to the federal government. You can manage the amount both State and Federal is taken out by adjusting your W-4, Personal Allowance Worksheet. Some companies allow you to make changes online, while others require you to visit your Human Resources department. States taxes vary by state—my home state of California is 6.6%, while New York is 9% (2017 rates).[2] Federal Income taxes vary by whether you’re married or single, and by how many “exemptions” you claim. With my income, claiming single and zero exemptions would give me a 12.8% federal income tax. In reality, I claim married with 5 exemptions for an 8.5% federal income tax. I choose to claim more so I get more in my paycheck monthly and receive less in my tax refund; while making sure I don’t owe anything either.

The federal income payroll taxes you pay monthly are estimations of your annual tax on your income. Like I mentioned above, by adjusting what you claim on your W-4 you can reduce or increase how much you pay per month. Depending on your personal situation, you may receive a tax refund or you may owe. If you get a refund, it means you paid more payroll taxes than you needed to. If you owe, then you didn’t pay enough. This generates a common debate amongst taxpayers—is getting a large tax refund a good thing? Mathematically, the answer is no. Continually striving to minimize the amount of taxes one pays is a pillar of a sound personal finance strategy. By maximizing your monthly income you can reduce debt and increase savings much quicker. That being said, behaviorally, people must look within themselves to see if they’re able to effectively utilize the additional money in your paycheck versus receiving a large tax refund. For some (many in my opinion), a large tax refund forces people to save. Unfortunately and only through anecdotal evidence, I feel most people don’t save the refund and make a large purchase instead. It’s really a personal choice; however, most certified financial planners will focus on you maximizing your monthly paycheck. Additionally and ideologically, some people acknowledge a danger of giving the government their own money during the year and then receiving it back without interest later the next year. In 2017, the IRS is already warning taxpayers that their tax returns may be delayed. The IRS will hold refunds for taxpayers claiming the Earned Income Tax Credit and Additional Child Tax Credit until February 15th, so there is some basis to that ideology.[3]

The taxes that you and your employer pay are the Social Security and the Medicare tax. These are both paid equally (50/50) by you and your employer—or completely if you’re self-employed. The total Social Security tax is 12.4%–with each paying 6.2%. Total Medicare tax is 2.9%–each paying 1.45%. So when you combine all the taxes, you’re looking at roughly 30% or more of your paycheck not going to you. In 2014, the average taxpayer paid 31% of his or her income to taxes.[4] This isn’t a conspiracy, it’s just how we created our financial genome in America. The picture below shows our current sequencing with taxes shown.

Genome – Payroll Taxes Connection

President Franklin Delano Roosevelt signed the Social Security Act in 1935. In 1937, Social Security was taken out in one lump sum and then the monthly payroll tax started in 1940.[5] The Medicare tax started in 1965. The Federal Income Payroll tax is different than the Social Security and Medicare payroll tax. The federal income tax originally started in 1861 to help pay for America’s Civil War, and then was repealed 10 years later. In 1913, with the ratification of the 16th amendment, the federal government gained the power to tax the income of individuals.[6]
Unlike the scenario in the beginning of the chapter, employers don’t discuss your net salary prior to mandated withholdings. When you apply for a job, you’re applying for the post-employer taxes salary; however, the salary advertised is before your own payroll taxes. When applying for jobs, you should automatically deduct 23-30% to figure your pre-insurance salary (we’ll talk about that in the next chapter). So the $100K a year job you’re looking at, may only be $70-$77K a year after payroll taxes.

When companies factor in labor costs, they are calculating your total salary. So that $100K salary that they’re advertising costs your employer an additional $7,650 (6.2% Social Security/1.45% Medicare) plus their portion of health insurance, retirement benefits, and any other employer-provided benefits. This is why companies are so resistant to support a federal minimum wage increase. It’s not simply an increase in wages, but a proportionate increase of employer-paid taxes and benefits. Fair wages isn’t as black and white as you may read on mainstream media—it’s actually very complicated, but that’s out of the scope of this chapter.

So far, we’ve only looked at the connection between your employer giving you a salary and how you don’t receive 100% of your salary due to payroll taxes and potential bank fees—but we’re still not to the point of receiving your salary. On top of Medicare, you must also pay for your own health insurance. In the next chapter we’ll look at health and life insurance before we talk about the connections once you finally receive your salary.

[1] (To M. Le Roy, 13 November, 1789)

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