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Chapter 9:
The government miracle of taxation

 

Part of increasing your awareness is knowing that when you earn money or enter into a transaction, such as buying clothes, you usually pay taxes. Even if your transaction is exempt from taxation, producing and delivering the product involves taxes on raw materials, taxes on machines that manufacture it, taxes on the wages of those working to assemble it, and on and on. Taxes are a huge part of everyone's expenses, but most of us don't really think about them the way we think about other expenses. Perhaps we feel we can't do anything about them.

Most of this feeling of lack of power over taxes comes from the mindset of being an employee. What you earn is reduced by a certain percent in income taxes, and there is very little you can do to change that percentage legally. Your solution then seems to be to earn more, which unfortunately can mean that a larger percentage in income taxes is taken. You may be able to reduce your income tax by a small percentage, such as by deducting interest paid on a home loan, or by investing in your own retirement plan. That little bit helps, but it doesn't make up for the fact that 20 to 30% of what you earn is taken from you.

The mindset of a business owner is different. Ordinary expenses incurred in business reduce the income subject to taxes. By following certain rules, the business owner can reduce his or her taxes far more than can the employee working for someone else. For example, having lunch with a friend becomes a business meal, buying a box of pens becomes office supplies, buying a computer becomes an expense (note 1), fixing your car's radiator becomes auto repair and maintenance, all which reduce your income subject to taxes.

Let's see the taxes in reverse effect to see how much you need to personally fund a shopping spree, assuming that your cash came from your paycheck.

Your US salary is $4,000 a month:
  • Taxes on your income total $1,200 (30%)
  •  Your salary is actually $2,800 a month

You spend $2,592 in a wild 3 hours:

  • The stores add $208 (8%) in sales tax
  • Your shopping spree: $2,800

So, in spending your entire monthly salary of $4,000, you only can buy $2,592 of goods; the other $1,408 (35% of your hard-earned salary) evaporates magically through the government miracle of taxation.

The effects on a business are different. The business earns $4,000, spends $4,000 in tax-deductible expenses, and pays no income taxes since it doesn't have a profit.

The more you can eliminate your need for cash in your life, the more cash you free up to get yourself financially stronger, and be able to take advantage of the opportunities that cross your path everyday. You'll say less and less: "If only I had the cash!" 

One of the reasons the rich keep on getting richer is that they have more bargaining power when they negotiate transactions. They may have a huge river of cash that can handle any level of expenses. More likely, they've eliminated a lot of unnecessary cash expenditures by reducing their expenses, used businesses to increase the deductibility of their expenses, found ways to pay for some of their needs with other than cash, such as forming a corporation and using its stock for payment, carefully put their cash into investments that create more money, and deeply understand the wisdom of harnessing market highs and lows contained in Bernard Baruch's statement about how he gained great wealth: "I buy my straw hats in the fall." 

Wealthy: a definition
One definition of being wealthy is the number of days forward you can sustain yourself and your affairs without working, a definition I found in the book Rich Dad, Poor Dad by Robert Kiyosaki. (note 2)  For example, if you have $3,000 in savings and your monthly expenses are $1,000, you have 3 months of wealth. If you get $1,000 each month in passive income (such as dividends and interest) and you have $1,000 a month in expenses, you can sustain yourself forever.

We can complicate this by factoring in taxes, increases in the costs of living, and the risk that your dividends and interest might decrease. But you get the idea of this definition of being wealthy.

If your monthly expenses are high and the only way you can pay for them is by putting in hours for a paycheck, then you have a very vicious cycle. Your major choices to exit the vicious cycle are:

  1. increase your income
  2. decrease your expenses
  3. increase your income and decrease your expenses.

The challenges in increasing your income are:

  1. taxes: you get only a portion of your increased income, and the more you make, the more you pay
  2. spending: it's easy to spend your new income; it takes discipline not to spend it away

Let's see this in action. 

1. Increase your income:
We'll assume you live and work in the US in the state of California and earn $48,000 in annual salary before paying income taxes. But you need extra money, so you'll get a part-time job paying $12,000 a year; you now earn $60,000. We'll also assume you have $33,000 in annual expenses.

Annual: Before After
  Earnings $48,000   $60,000  
  30% taxes on earnings -   14,400    -   18,000  
  Available for expenses 33,600   42,000  
  Expenses -   33,000   -   33,000  
  Annual Savings     $     600   9,000  
  Increased Savings $ 8,400  

Can you can see that you only $8,400 for your $12,000 part-time job? The rest evaporates magically through the government miracle of taxation.

With your $8,400 extra a year, or $350 per paycheck, you now need to lead yourself away from the temptation of spending it on new stuff. The challenge here is that we all are human, none of us is perfect, and unless we have really disciplined ourselves over the years by watching where our money goes, we can easily watch our money go.

Let's take a look at the challenge of creating wealth from the opposite side, by decreasing expenses.

2. Decrease your expenses:
Again, we assume you're in California, earning $48,000 annually with $33,000 in annual expenses. This time, you decrease your expenses by $8,400 a year, or $700 a month:

Annual: Before After
  Earnings $48,000   $48,000  
  30% taxes on earnings -   14,400    -   14,400  
  Available for expenses 33,600   33,600  
  Expenses -   33,000   -   24,600  
  Annual Savings     $     600   9,000  
  Increased Savings $ 8,400  

In this example, you didn't need to get another job. But you saved the same amount of money. In reducing your expenses, you also gained some extra benefits:

  1. You learned through experience how to reduce your expenses. You did more than read about it.
  2. Your experience helps you reduce other expenses. In other words, the more you practice, the better you get, like riding a bicycle.
  3. You kept your free time available to spend doing those things you enjoy with those people you love rather than draining your time and energy at another job.

You may be screaming that it's impossible to reduce your expenses by $700 a month. Remember that perception is reality, and keep your mind open to the possibility that it is possible.

 
3. Increase your income and decrease your expenses:
Of course, nothing prevents you from increasing your income with the part-time job while reducing expenses in order to reach the same goal of saving $9,000.

If your expenses are out of control, you may need the extra part-time income temporarily in order to regain control. Once you do have control, then you can quit your part-time job and continue to focus on reducing your expenses, rather than increasing them again.

Those are the three ideas for exiting the vicious cycle of high monthly expenses combined with a lower income.

Some of those expenses may come from confusing your needs with your wants. It's very easy to do, and the message is reinforced by the messages all around you, from advertising to peer pressure and your own internal voice.

Needs and Wants

Often, we declare a certain expense as a "need" when in fact it is a "want." You have already read my own example of taking on too much office space in "But I really need it." The following examples aren't listed to make you feel guilty. But perhaps some of them will encourage you to seriously consider the difference between needs and wants in your life, help you put them into perspective, and then give you the emotional room to cut your expenses without feeling too uncomfortable.

Housing, food, and clothing:

  • You are single and need a decent apartment (studio-sized), yet you want to continue living in a spacious $1,500-a- month, 2-bedroom unit in the best part of town
  • You need to eat lunch, yet you want to buy your salad and blended smoothie at $8 a day
  • Your body needs water, yet you want soda
  • You need coffee, yet you buy a $1.55 cup of Starbucks® on the way to work each day
  • You need food to cook at home and can shop with your friend who has a Costco® wholesale food membership, yet you continue to pay premium prices at the corner store
  • You need presentable, appropriate work clothes, but you want the latest fashions from the high-priced brands

Communications:

  • You need an internet connection, yet you want a high-speed connection
  • You need phone access on the move, but you want a $50-a-month cell phone plan

Entertainment:

  • You need entertainment, yet you want to continue paying $50 a month for cable TV

Transportation:

  • You need to get to work, yet you want to drive each day, paying for parking, gas, and wear and tear on your car
  • You truly need a car for transportation, yet you want to drive a leased Mercedes or Lexus

(By the way, the examples above add up to more than $700 a month.)

Some of your wants may come from your idea of how to present yourself to others. Most, if not all of us, want to be successful. Yet, many of us confuse the appearance of success through luxury possessions with true success. An extremely opposite example is found in the late Sam Walton, billionaire founder of Wal-Mart, famous for touring around in an old pickup trick. And years ago, I read in The Wall Street Journal of a Detroit man worth $400 million. He had an old rusted car which he drove everywhere, even to high society events, which embarrassed his less wealthy peers. 

A wonderful book profiling the absence of excessive spending and conspicuous consumption among the wealthy is The Millionaire Next Door by Thomas J. Stanley and William D. Danko.

Businesses also fall prey to keeping up appearances. Peter Lynch, former investment fund manager for the huge Fidelity Magellan Fund, describes visiting corporate headquarters for different public companies:

"At Crown, Cork, and Seal, I noticed that the president's office had a scenic view of the can lines, the floors were faded linoleum, and the office furniture was shabbier than stuff I sat on in the Army. Now there's a company with the right priorities - and you know what's happened to the stock? It's gone up 280-fold in the last thirty years." (note 3)

Remember: challenge yourself to find alternatives, start with small steps, and master the process. Then you'll be comfortable when you move onto bigger steps. 

You even may have to evaluate the cost of contractual penalties in canceling contracts against what you will save, such as those in cell phone, premium cable and satellite TV, and leased car agreements.

Also, be aware that finding ways to reduce your expenses does not mean that you will never again have those things you gave up. If your housing, car, or dining expenses are too high now, reducing your expenses now can help you have that large house, fancy car, or 4-star dining experience later when it's less of a financial strain. You might even enjoy it more later, having freed yourself from the stress of financing their expense.


Notes:

  1. In the US, a business can claim up to $24,000 annually (2002 tax year) as expenses on what are normally considered assets to be depreciated over time. Therefore, you can buy a $20,000 car and a $4,000 computer and deduct them as expenses in the tax year you purchased them. Get more information about IRC Section 179 asset expensing from your tax advisor and in IRS Form 4562 from IRS.gov.
  2. Robert T. Kiyosaki with Sharon L. Lechter, Rich Dad, Poor Dad. New York: Warner Books, 2000, page 80.
  3. Peter Lynch with John Rothchild, One Up on Wall Street. New York: Penguin Books, 1990, page 189. 

I hope you have enjoyed Parts I and II of Hidden Opportunities. This book also contains Parts III - V (chapters 10 - 18), and a bibliography with 21 book titles that can help you both increase your perception and creativity and solidify your financial skills.

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