One of my favorite concepts to tell people about is “affordable luxuries,” the things that barely make a dent in your bank account but immediately spark joy: cheap candles, nice towels, or a new filter in your refrigerator. There are times when spending a lot of money will make you a lot happier, and there are times when spending just a buck or two will make you even happier, and I love sharing all the latter situations I run into.
There’s a parallel situation, which I call “cheap lessons.” In a cheap lesson, you don’t come out feeling good on the other side; you come out knowing something you didn’t know beforehand. It may hurt, but what makes it cheap is that you don’t suffer more than absolutely necessary to learn it.
Trading individual stocks
My first cheap lesson was all the way back in high school, when I started looking at the wall of stock quotes listed in the local paper (local papers had stock quotes back in those days). My mom’s stockbroker was a friend of the family so I was at least vaguely familiar with the concept of a stock market, and I asked if I could pick a stock. I dutifully studied the list of quotes, thoroughly researched a few companies (meaning I looked at the America OnLine stock market forums), and then picked one at random. For the life of me I can’t remember the name of the company, but I do remember the ticker, “G,” and that the company had something to do with service station gas pump technology. I don’t think they made the gas pumps themselves, but they might have written software for them or something.
Every day I would open the paper and check my stock’s price. The first few days were a whirlwind, with the stock doubling or tripling in price! Then the stock collapsed and never recovered. A week or two later it wasn’t listed in the newspaper at all, and a little more time on the AOL forums revealed the company had filed for bankruptcy to protect it from a tsunami of lawsuits. To this day I have no idea if it was a pump-and-dump scam or just another victim of the first internet bubble.
What makes this a cheap lesson? First, I was playing with someone else’s money and second, I picked a cheap stock, so the maximum loss was limited by the purchase price — you can’t lose more than you pay. In hindsight, my mom also got to deduct the capital loss from her ordinary income during her peak earning years, so it ended up being a cheap lesson for her to teach as well.
There’s an unfortunately common idea that tax deductions and various other scams mean that it’s often better to lose money than to make money. And it’s true that there are a few corner cases I’ve written about in the past where that’s true: in 2019, a single filer with only earned income who maxed out their traditional IRA and 401(k) contributions and then earned the single additional dollar that tipped their adjusted gross income from $19,250 to $19,251 would see the value of their Retirement Savings Contributions Credit slashed from $703 (eliminating their federal income tax liability) to $400 (owing $308).
Likewise, it’s true that it’s sometimes necessary to spend money in order to make money: if you need a car to get to work, the cost of the car doesn’t exist in a vacuum, rather it’s a necessary input into your income stream, the same as a carpenter’s hammer or a surveyor’s tripod. But the fact you might claim a tax deduction for your expenses almost never makes them free: you’re almost always better off financially spending less rather than more.
Another lesson I was fortunate to learn young was the yawning chasm between the wage your employer offers you and the amount of money you see in your paycheck. This is a lesson experienced workers take for granted, but the only way to really learn it is to see your first paycheck. In high school I took a job for maybe 10 hours a week at the local Boys and Girls Club doing a few menial chores like signing video games and pool balls in and out. I didn’t work very hard and they didn’t pay me very much, so it seemed like a pretty good deal. But when my first paycheck came, imagine my surprise that I wasn’t earning $51.50 a week (the federal minimum at the time was $5.15 per hour), but just $47.56. I stormed into my boss’s office to demand an explanation, and to her credit she walked me through the paystub and explained each deduction to me.
Of course, the problem with the US income tax system isn’t that our rates are too high — our rates are far too low, especially on high incomes and capital gains. The problem is that it’s too complicated. Take a look at the possible trajectory of a young person’s take-home pay over time:
- In high school, they take a part-time job that pays the full 7.65% FICA tax on all earnings, but are exempt from filing income taxes because their earned income is below $12,000 — unless they had state or federal income taxes withheld, in which case they must file in order to claim their refund.
- Their freshman year of college, their financial aid package includes an undergraduate work-study job that is exempt from FICA taxes during the school year, but is still subject to federal and state income taxes.
- The summer after freshman year, they keep the exact same part-time job at the university, but see their take-home pay drop 7.65% since it’s subject to FICA taxes whenever they are not actively enrolled in classes.
- Sophomore year, they lose their work-study grant and can’t find a non-work-study job on campus (many campus make-work jobs are restricted to work-study grantees), so they work 20 hours a week at an off-campus restaurant. Their income during the school year continues to be subject to FICA and state and local income taxes.
And we wonder why people have a hard time budgeting. As this “simple” example illustrates, the difference between salary and take-home pay is one of the most important lessons you can learn, and it’s best to learn it as cheaply as possible. Most of the benefits documents I’ve reviewed over the years were pretty good about spelling out the costs and benefits of various programs (health, life, and disability insurance, for instance), but made no attempt to translate a salary offer into a realistic take-home pay amount.
Let’s skip forward to our young scholar’s graduation, when they take a new job in the big city at the generous salary of $45,000 per year, with a start date of September 1 (we’ll say they took the summer off to hike the Appalachian Trail). Conscientious of the federal guideline for “housing burden” to spend no more than 30% of their income on housing, they rent an apartment for $1,125 per month. Unfortunately, after their FICA taxes are deducted, this already leaves them paying 32.5% of their take-home pay in rent. Fortunately, they only worked 4 months at the new job, so their federal and state income taxes are minimal. The next year, things get worse. Now their paycheck is reduced by the same FICA taxes of $287 per month, but also federal income taxes of $312, leaving them just $3151 per month in take-home pay. Now they’re paying almost 36% of their take-home pay in rent.
In my experience, most problems have an easy solution and a right solution, and more or less everybody knows what the right solution is. They just don’t want to do it, because it’s hard. The easy solution to the take-home pay problem is to lean on parents to “educate” their children about the nuances of federal tax law (about which they themselves know nothing), and blame it on them when they get it wrong. It doesn’t solve anything, but it also doesn’t cost anything, which is what makes it so easy.
The right solution is to simplify the law. Make all income subject to FICA. Treat all income identically. Abolish workplace retirement savings accounts. End phased-in means-testing. End phased-out means-testing. Stop creating targeted tax breaks for con artists.
Hard things are hard because they’re hard, and not everyone has it in them to do what’s right. But if you can’t be part of the right solution, you should get out of the way, not promote “personal finance education” as an alternative.