Sunday, February 27, 2011

The 3 Places you can Spend your Money

The 3 Places you Spend Money

Have you ever thought about every dollar you have ever made and exactly where you spent it? Sometimes big purchases stick out like when I bought my wife’s engagement ring, or the $100 I spent on a pager when I was a senior in high school (I know I am showing my age a little). Throughout a lifetime there is only a single pool of money we will earn and even for the average person that can be multiple millions of dollars. Creating wealth however, depends on the stewardship we have towards this money and where we chose to place it. Below are the 3 places we can put money:

#1 Lifestyle: This is the money we use in our everyday life to buy things like food, clothing, and entertainment. One of the biggest influences on lifestyle expenses is your home (typically the bigger the home the bigger the expenses associated with it). Often when trying to focus on creating more wealth Lifestyle is the only place most folks (and “so-called” experts) concentrate. If you’re like most people working hard 40+ hours a week only to eat beans & rice, and drive a beat up used car is not your idea of Lifestyle then we think very much alike. However, this is exactly how most financial experts help folks try to create wealth. I am not saying lifestyle should not be reviewed to help create wealth, but it should not be the sole source.

#2 Future Savings: This is the money we are able to save. This could be money in your checking account, savings rainy day fund, life insurance cash values, or a retirement plan. Ultimately this is the measuring stick for wealth for most people. Until the recent financial crisis many people were saving next to nothing for the future. Fortunately the savings rate is up over the last few years; however I think it could go even higher if we all could focus on the third place our money goes (see below).

#3 Transferred Money: This is the money we transfer to other institutions with no real apparent value lifestyle wise or economically. Transfer money includes but it not limited to things such as:

• Interest on debt (such as credit cards, car loans, personal loans, and home loans)

• Taxes (such as federal, state, local, S.S. taxes, Medicaid/Medicare, sales tax, gas tax, property,
and on-on i.e. there are too many taxes to list)

• Insurance expenses (such as health, car, home owners, and term life)

• Fees (401k admin fees, bank fees, late fees, mutual fund fees, etc.)

There is also a concept within transferred money that is called “Opportunity Costs”. The idea is when you transfer money not only did you lose those dollars, but you also lost the interest those dollars could have earned had you avoided the transfer altogether.

For instance if you had a regular savings account you were saving $5,000 per year into and was earning 5% per year (interest rates are historically low now so I have assumed a higher Rate of return for illustrations purposes only). You would earn $250 in interest in year 1 and owe $75 (30% assuming 25% federal and 5% state) in taxes. An opportunity cost says not only did you lose the $75 but you also lost the future interest the $75 could have made (because you could have saved more if you did not have to pay the $75 tax). If this happened every year for 30 years at a modest rate of return of 5% then your account value would be $348,804, however you would need to subtract the taxes paid and opportunity cost of those taxes. The total taxes paid plus their opportunity cost = $94,829. This would leave you with a net account value of $253,975. So in summary this one decision alone costs this individual almost more than they earned in interest. See below:

$150,000 (total investment $5,000 * 30)

$198,804 (gross interest) – $94,829 (Taxes + Opportunity cost on taxes) = $103,975 (Net Interest Earned)

See the survey to the right and click on which you think might be a better option to create more wealth.

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