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David Bach The Automatic Millionaire

David Bach, The Automatic Millionaire

Save First, Pay Taxes Later

by David Bach

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Very Good (19 Ratings)
3.947368/5
Posted on Tuesday, January 3, 2006, 12:00AM
Most people pay everyone else first -- taxman, landlord, credit-card company, and so on. They try and budget every week, month, and year hoping that if they're careful they'll have some money left over.

This is absolutely, positively backwards. And because of it over 70 percent of Americans continue to live paycheck to paycheck regardless of increasing incomes. We make more. We spend more. And at the end of the day we're still broke. Are you tired of this game?

"Pay yourself first" means just what it says: When you earn a dollar, the first person you pay is you. Sounds simple, but most people don't do it.

Instead, the first person they pay is Uncle Sam. They earn a dollar and before they even see it, they pay around 20 to 30 cents in federal income tax. Depending on the state they live in, they may pay another 5 cents in state income tax. On top of that, there's Social Security, Medicaid, and unemployment. In the end, the government gets as much as 35 to 40 cents of their hard-earned dollars.

The Taxman Gets Smart

The government didn't always get first dibs on our paychecks. Before 1943, folks got their hard-earned paychecks first and paid taxes later. There was a problem with this system, however: People weren't saving enough money to pay their taxes. They spent what they earned and when it came time to pay taxes they didn't have the money.

So the government created a system under which it got paid automatically every time we got paid. And that system has worked for the government for over 60 years. But how is it working for you?

My point here is not to have you break the law, but rather learn from the government.

You have a right to legally avoid federal and state taxes on the money you earn. You can legally pay yourself first by simply using a retirement account. There are many different types, including 401(k) and 403(b) plans, IRAs and SEP IRAs. The one thing that makes all of these "pay yourself first" accounts is that the money you put in them is either pre-tax or tax deductible.

$14 a Day Could Grow Into a Cool Million

The most common question I get asked is, "How much should I save?" Your goal should be to save one hour a day of your income.

If you start this week by having one hour a day of your income deposited into a 401(k) plan at work, you will be in fantastic shape. If your employer doesn't offer a retirement account, go to a bank or brokerage firm (on- or offline) and set one up.

Let's assume you make $50,000 a year. That's about $2,000 every two weeks, which is how most people are paid. So to save 10 percent of your income, which is less than an hour a day of savings, you'd have to save $200 every two weeks -- or $14 a day.

If you invested $200 every two weeks for 35 years in a retirement account that earned an annual return of 10 percent what would you have? Quite a pot of gold: $1,678,293.78.

Depending on how you calculate this and compound the interest it could be higher or lower, so don't waste time debating the calculation. The point is you can make a lot by setting up a retirement account that pays you before Uncle Sam takes his cut.

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5 Comments

Showing comments 1-5 of 5

  • B W - Saturday, October 6, 2007, 5:03PM ET  Report Abuse

    • Overall: 4/5

    I like the concept of pay myself first. I also like the one about letting time and placement of my investments make it double over and over and over. I go with two of the largest Mutual fund companies, and so far get over 28% on all of them right now year to date. I did not know you could set up a 401K on your own. Thank you David, that was a great Pearl of Wisdom. I will max my Roth IRA with about 115K in it every year. 401K I had at 30% as long as I could stand it, dropped down to 10% for awhile during child support and alimony and loss of military retirement that I held her at 36.98% for the rest of my life. Had I known I did not need a company with 401K offered, I probably would have had it set up the day after my divorce became final. My Priorities are: Pay credit card in full every time. Pay Principal reductions and minimize interest payments, which I can and do use for quality of life and home improvements, and non retirement investments. If the non retirement investments are doing well, I can always take from them to feed the Roth in full. Roth has been my vehicle of choice because what I take out of it is tax payed already when I retire from my second career. The 401K is new for me but allows me to shield a lot of my income from taxes. My company matching is pretty good, but not that central to my plan. The main thing is having my 401K in the right accounts and diversified fairly well, and also max it out as much as I can each year. Roth I have had for about 15 years, and stopped feeding it when I realized I was divorcing. I check my fund placement from time to time, and may or may not end up moving it from one account to a better performer every 2 to 6 years. The retirement accounts do not cause any problems, but even shifting a non retirement account to another without taking the money, gets the IRS's panties in a bunch. Penalties fall under wasted income, like unavoidable interest payments. The max you can owe the IRS you is paying in 1K above what was automatically deducted from all of your incomes. You can owe more than that for one year, but that is to give you time to shift to quarterly payments of projected tax debt you may owe to the IRS at the end of the year. I try to owe them a check for $990 each year, through exemptions I claim and also the amount of taxes I pay when I claim my money from an investment in a non retirement account. ie... 20K per year for High School for my son living in Japan taken from a court liquidated fund during the divorce. Keep easily findable financial records for your accounts and investments. If the IRS should come after Penalties and Interest for something you invested 20 years ago, be ready.... I saved over 4K in penalties and interest for just such an event this year. Proof taken and applied. I strongly favor the Everything you Buy USAGE Tax over the IRS system. It will be interesting if they ever implement it, and Life should be much better for all Americans as a result. Thank you for reading my comments. I wish you well on your investments. Brad

  • allenEv - Monday, October 1, 2007, 3:32PM ET  Report Abuse

    • Overall: 1/5

    It is a bad idea to lock so much of your cash flow into a retirement account. You will end up with bloated credit cards debt and not be able to access the IRA money.

  • Loo - Sunday, September 30, 2007, 9:55PM ET  Report Abuse

    • Overall: 5/5

    A simple idea, but not applicable to place I live. However, we hav ecompulsory saving per month, of around 30% of pay. Should be good enough, I think.

  • Stephen M - Thursday, September 27, 2007, 8:18AM ET  Report Abuse

    • Overall: 5/5

    David Bach delivers a message that every worker should heed.

  • vilgelm - Tuesday, September 25, 2007, 3:34PM ET  Report Abuse

    • Overall: 5/5

    Very good advice

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