Let’s talk about income. Although income may seem pretty straightforward, the implications of income are actually rather nuanced.
For the vast majority of the population, a person’s salary is his or her largest source of income (we will cover income diversification in a later post). And most people I’ve spoken to about financial woes seem to immediately lament their income and wish for a higher salary. This is unfortunate for two reasons. One is structural, there is wage stagnation in the United States, with salary increases almost on par with inflation. Although unfair, it is not likely to change dramatically in the near term. Secondly, in addition to salary increases not being meaningful or realistic, a higher salary isn’t as powerful as you may think. Here’s why.
Let’s start with this age-old adage often attributed to Benjamin Franklin; “A Penny Saved is a Penny Earned”. This simple phrase seems to suggest that saving a specific sum is equivalent to earning the same sum. Is a penny unspent actually equal to a penny earned? Well not really. When you take into account taxes, a penny earned much less than a penny saved.
Often times people think about income as the total salary you earn, however one’s real income is much lower than one’s stated salary. This is due to taxes. If you make $75,000 in NYC, your take home salary, after tax is $53,062. This means that $1 of your stated salary equals $0.71 in real terms. So, if your salary was increased by $10,000, your real take home salary only increased by $7,075. It’s still a nice increase, but not quite $10,000. Now if you were able to reduce your spending (remember this is money that you have in your pocket, so already post-tax) by $10,000, that means you’d actually have $10,000 more real dollars. This is almost $3,000 more than a $10,000 raise in your stated salary. All of that to say, an increase in salary isn’t actually as powerful as the same reduction in spending.
So, what did Franklin mean? Well according to this article in Forbes, the actual phrase was something like “A penny saved is two pence clear” suggesting that Franklin is talking about Opportunity Cost. Essentially, the article argues that he was trying to teach a lesson that spending one penny actually means you’ll have to add two pennies in order to be in the same place as someone that didn’t spend the one penny in the first place.
Think of it this way, there are two people, Angela and Peter and they each have a net worth of $0. Today they each earn $5. Angela puts her $5 in a savings account, and Peter spends his $5 on a latte. Angela’s net worth is now $5 and Peter’s net worth is now -$5. If Peter wants to have the same net worth as Angela, he now has to add $10 to his savings account. This is an important concept that is often ignored or not understood. People generally think of their financial situation as an Income Statement – (Income – Expenses = Earnings), but to weigh the true cost of financial decisions, it is important to look at your finances as a Balance Sheet (Assets – Liabilities = Net Worth).
The true impact of income isn’t the income in and of itself, the true impact of income has much more to do with the choices you make with the income you earn. Post-tax dollars are much more impactful than pre-tax dollars and your spending choices are not just about spending, but also the opportunity cost of your spending on your net worth.
*For this analysis, I used this handy calculator on SmartAssets
Photo by Nazym Jumadilova on Unsplash