Planning Basics: The 5 things you can do with your income

This is the first in a series on Planning Basics using the Haddam Road Model. Future posts will focus on the basics regarding Expenses (or ‘your lifestyle’), Assets (‘things held for future benefit’), and Liabilities (‘obligations against future income’).

Below is the basic structure of any financial plan; the top elements create a flow (of cash) and the bottom two fluctuate in value over time.

So, what are the 5 things you can do with your Income?   These are the 5 options: Pay Tax, Live Life, Invest, Pay Debt, Defer.

1. Pay tax: Unfortunately, most likely you will be paying some current Income tax obligation, be it through Income tax withholding, quarterly estimates, a consumption tax like sales tax or tolls, property taxes… I’ll stop there.  Taxes and interest on debt are the two biggest headwinds one encounters in personal planning.  How much can you expect to pay in taxes over your life?  

Here’s an estimate: 

https://www.forbes.com/sites/moneybuilder/2011/03/17/how-much-do-you-pay-in-taxes-over-your-lifetime/#7eccb9c06e95.  

Taxes keep government services running which is a good thing but it’s still not fun to watch it go.  

2. Live your life!  Obviously we need income to fund our current lifestyle from the basics (food, clothing, shelter) and to all other potentially self-actualizing activities (other than meditation, which is free).  We’ll touch on this in a later post but generally ‘living’ expenses, after providing the basics of survival, offer:

• The ability to free up time and focus on less mundane aspects of life.

• The ability to grow personally or professionally

• The offer of convenience (services for cooking, cleaning, transport, etc.)

• This is an incredibly American trait, our society like none other is focused on convenience and will pay a ridiculous premium for it.

Living in the moment in a Vegas style life is fun, but what about tomorrow?  What can you do with your Net Cash Flow to provide for tomorrow?  Here’s three basic options.

3. Invest it.  There are two basic financial options and two personal options within this choice: 

• Buy something that creates more income, a future benefit.  Examples: a bond that pays interest, a stock that pays dividends, or real estate purchased for rental.

• Buy something that has the potential to grow in value, another potential future benefit.  A stock with high growth potential, speculative real estate, precious metals, artwork, and other ‘conceptual’ investments (see “Campbells Soup Investing: Product vs Concept”): https://haddamroad.com/insights/campbells-soup-investing-product-vs-concept 

• Invest in yourself.  Expand your skill set, obtain a new credential, show mastery of a particular subject.  The goal here is to make you the ‘income producing vehicle’ and to position yourself higher up the compensation ladder of your organization or in the general employment market.

• Invest in others.  Family, Community, causes important to you; potentially very challenging and extremely rewarding if executed properly.

4. Pay off an obligation against your future income, otherwise known as ‘pay down your credit card balance’...  This creates a current and future benefit by reducing the cash flow going to service your debt (ie paying interest).  

• As a very general rule, look to pay off a debt obligation that has a 6% or higher interest rate rather than investing the residual cash flow (which is about the rate one would receive if invested in a B-rated corporate bond).

5. Defer it.  There are many options here (which we’ll cover in a later post) but the most common are:

• Defer paying tax sometime into the future - this is the basic structure of the IRA, 401k, or SEP.  Tax is paid on any withdrawals from the account (with some other rules involved too).

• Actually recognize the income as taxable and then fund an account where all income and gains are not taxed in the future, this is the Roth IRA.

• Roll a realized investment of ‘real property’ into an investment of the same type.  The IRS calls this a ‘like-kind exchange of real property’ and has a ton of rules which we won’t touch on here.

• There are other wrinkles like a Health Savings Account which allow non-taxable contributions and distributions within certain limits.

Within these options are a lot of planning opportunities (and pitfalls) which can result in meaningful headwinds or tailwinds for your financial future.   

What is the proper balance for you and your family?  Do you keep your surplus ‘liquid’ or do you look to defer taxes?  What is the best investment given my current situation?  That is the art and science of planning.

TIPS:

• Reward yourself by being diligent with your taxes.  Take every deduction available to you and keep good records (I know, it’s a challenge). With every legitimate deduction you record you are in effect paying yourself.  If you can save yourself $1000 in taxes and your bracket is 25% you’ve effectively recaptured $4,000 worth of your time.  It may be worth consulting a tax advisor.

• We’ll cover Expenses and Lifestyle in a later post but suffice it to say that people generally underestimate the cost of their lifestyle (personally my jaw drops when I look at my cost of parking (and tickets…) over the course of the year).   Grab 3 months of bank statements and take a detailed look at what you’ve spent.  It may be eye opening. 

• Invest in you, it is the best way to increase your earning potential over time.

• Time is the biggest asset you possess.  Don’t waste it worrying, act.

Our goal with the Haddam Road Model is to simplify the complexities of personal finance and explain the basics so you understand the implications of each financial decision.  We’ve simplified the options related to income, we’ll focus on other quadrants in future posts.  Over time you’ll see how this all fits together and will arm you with the tools you need to evaluate any financial decision.  

I enjoy working with clients who want to understand their finances and be actively involved in shaping their future.  Please contact me if you have any questions or comments.

© 2019 Haddam Road Advisors.  All rights reserved.

Brian Kearns, CPA

Haddam Road Advisors

Ph: 312 636 3067

www.haddamroad.com

NOTE:  This is being provided for informational purposes only and should not be construed as a recommendation to buy or sell any specific securities. Past performance is no guarantee of future results and all investing involves risk. Index returns shown are not reflective of actual performance nor reflect fees and expenses applicable to investing.  One cannot invest directly in an index.  The views expressed are those of Haddam Road Advisors and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates.

Investment advisory services offered through Mutual Advisors, LLC DBA Haddam Road Advisors, a SEC registered investment adviser.