Here, I will seek to define several common personal finance terms that are often conflated and misunderstood.

Financial Literacy: There is no consensus definition of financial literacy, but I would say it is mainly concerned with having financial knowledge. However, personal finance is an eclectic field; having a high level of financial literacy requires knowledge in other areas, such as behavioral economics, psychology, information literacy, law, and even nutrition. Although financial literacy is usually correlated with good financial practices, this is not a given; one can easily have expertise but fail to apply it, or succumb to believing they are exceptional and can earn more in the stock market than others, or miraculously avoid a probable, deleterious outcome.

Financial Capability: I would define this as financial literacy combined with demonstrated financial competence, which hinges on consistently making good financial decisions, given one’s available choices and opportunities. What constitutes a “good” financial decision is not always clear, but we can often put items in rank order. For example, taking a payday loan is objectively worse than taking a credit card cash advance, because payday loans have far higher interest rates. One can have financial capability but not be able to do much with it—for instance, marginalized peoples and those in adverse situations. Conversely, privileged people may squander a portion of their privilege due to low financial capability. To be financial capable, one must not only make good financial decisions but also know why their decisions are good, and why they selected them over alternative courses of action. Such expertise should result in repeated beneficent decision-making, whereas someone of low financial capability might make a good choice by chance, but is unlikely to reliably do so.

Gambling: Many people conflate gambling and investing, but they are not the same thing. I define gambling as an act or series of acts where you are more likely to lose money than not, meaning that your expected returns are negative. However, there is an exception for insurance that insures against unmanageable losses, including losses that may potentially be unlimited (e.g., health insurance). Obviously, insurance companies have to come out ahead overall, but insurance is worthwhile to insure against unlikely but highly deleterious financial events. Returning to the element of likelihood, any student of statistics knows that if you gamble $1 with a 49% probability of coming away with $2 but a 51% probability of coming away with zero, your odds of making money are close to 50:50. But, if you keep making this bet again and again, your probability of losing money overall gets closer and closer to 100%. This is how lotteries and casinos produce guaranteed profits. When you invest in a broad swath of the stock market (e.g., an S&P 500 index fund), your probability of making money on any one trading day is about 54%. However, in a given year, it is about 83%, and in a given 10-year span, it is about 91%. Assuming you don’t need the money for a long time, this is investing, not gambling. However, if you try to pick stocks or put all your money in your company’s stock, your expected return might be negative, and there is a large risk of catastrophic loss. This is gambling. A kinder word is speculating, but it is certainly not investing.

Speculating: If you pick individual stocks or even entire market sectors, you are basically speculating. Buying gold, silver, oil, or corn futures is speculation. Buying BitCoin is speculation. These assets don’t have a solid track record of producing real returns (after adjusting for inflation). Modern portfolio theory tells us that holding uncorrelated (diversified) assets can be advantageous, so it makes sense to have gold—but not more than a small percentage of your assets. Speculation is often better than gambling, but certainly worse (as a decision) than investing. Although you might have fantastic results from speculating, this just means you had the unlikely fortune of making a bad decision that resulted in a good outcome. However, if this inflates your ego, it can easily lead to future misfortunes!

Investing: Over time, investing results in a probability of real returns that approaches 100%. As Vanguard mentions, for an S&P 500 index fund, which consists of 500 of the largest U.S. public companies invested proportionate to the companies’ market valuations, your probability of positive returns on any given day is 54%, but in ten years it is 91% (based on 1988–2018 data, but others have shown similar results even going back 100+ years). Besides the stock market, one can be successful at investing in real estate, or even one’s education, as those with more education tend to be more happy and successful in life, including financial success. Of course, there is presently a student loan “crisis” going on, and it is important to avoid high-cost tuition and housing expenses while also finishing your degree. On another note, investments must have a high probability of succeeding within a reasonable timeframe, and what is investing for one person could be gambling for another based on how soon they need the money (e.g., older people should have “safer” investments meaning less risk of short- and medium-term losses and lower expected returns).

I will follow this up with a Part 2 in the near future.

Although income tax is more salient, most Americans pay more in payroll taxes. These are the Social Security and Medicare deductions you see on each paystub (a.k.a. FICA or OASDI). Income taxes are progressive, meaning taxpayers pay a progressively higher percentage of their incomes as their incomes increase. Payroll taxes, on the other hand, are regressive, meaning taxpayers pay a flat and/or decreasing percentage of their incomes as their incomes increase. This results in an unusual and unfair phenomenon where 76% of taxpaying Americans actually pay more payroll taxes than federal income taxes.

How do payroll taxes work? A fixed percentage of your gross wages are deducted by your employer each pay period, paid to the federal government. This percentage, as of 2018, is 6.2% for Social Security and 1.45% for Medicare, for a combined total of 7.65%. Many employees do not know this, but your employer also must contribute 6.2% for Social Security and 1.45% for Medicare behind-the-scenes, which is another 7.65% bringing your total tax to 15.3%. This means that when a job is advertised for $10.00 per hour, your employer actually is paying $10.77 per hour if we include their share of these taxes, and even more if we also consider unemployment tax, workers’ compensation insurance, and other obligations. Although payroll taxes do not apply to some employees and employers, such as myself as a Graduate Teaching Associate at University of Central Florida, these exceptions are uncommon.

If you are self-employed, you must pay the full 15.3% of payroll taxes out-of-pocket. This is a shock for many sole proprietors, such as freelancers. The IRS expects tax payments on a quarterly basis, rather than a lump sum after the tax year ends (if you were an employee, they would be getting the money in advance from each paycheck). Your business expenses, such as miles driven in a car, may be deducted to reduce the earned income to which payroll and income taxes apply (keeping excellent records and employing an accountant is recommended).

With income tax, nearly half of Americans get all the money back (or more) in their tax refunds. A good chunk of your income is exempt (the standard personal deduction), and tax credits, most notably the Earned Income Tax Credit, soak up whatever other tax is owed and provide a sizable refund for low- and middle-earning people who have children. This stands in stark contrast to payroll taxes, for which there is no refund. (Except in the unusual case where you had multiple employers and earned more than $128,400 [2018 cap] in combination between them, in which case you can get a refund from the IRS for the excess 6.2% Social Security tax you paid on amounts exceeding $128,400.)

The IRS, as directed by existing laws/regulations and the U.S. Congress, makes an important distinction between earned and unearned income. Earned income consists of typical employment wages, including self-employment, and is subjected to payroll taxes. Unearned income includes bank account interest, dividends, capital gains, and Social Security benefits, which are not subject to payroll taxes. With qualified dividends and capital gains, the income tax rates are lower too; about half that of ordinary, earned income. This is an enormous benefit to investors in equities (stocks), who already benefit from the huge capital gains that equities reliably provide over long periods of time. It’s also an enormous disadvantage to most Americans, who work but do not invest, and is a primary contributor to wealth inequality and disenfranchisement.

Although payment of payroll taxes is compulsory and factors into the amount of Social Security benefits you receive each month in retirement, in a U.S. Supreme Court case from 1960, it was decided that paying payroll taxes does not entitle you to anything. The plaintiff in this case was deported for being a communist, and thus his Social Security benefits were revoked despite having paid payroll taxes for 19 years, which the court upheld.

Nonetheless, most Americans can count on receiving their benefits if they survive to retirement age. However, many caution that the system will become unsustainable by the time today’s emerging adults reach retirement age. But, this is a product of tax policy: Social Security tax unfairly rewards high earners by pulling a vanishing act for wages above $128,400 per year. This means if someone earns $200,000 per year at one employer, the government collects 12.4% in Social Security tax on their first $128,400 in wages, but collects 0% on the next $71,600 of wages. Incredible. We could make Social Security solvent by eliminating the cap. Bernie Sanders suggested raising the cap to $250,000 in wages during his 2016 presidential campaign, which has been criticized as extending solvency only from 2034 to the year 2055, but removing the cap entirely would probably do the trick, while maintaining Social Security’s standing as a regressive tax. It would merely be less regressive than it is now.

With Medicare tax, which is 2.9% divided equally between employer and employee, there is already no cap. In fact, for earned income above $200,000, employees have to pay an extra 0.9%, bringing the total tax to 3.8%, and meaning the Medicare portion of payroll taxes might actually be classified as progressive. As we can see here, if removing the Social Security cap proves insufficient, there is already a precedent for having an uncapped payroll tax that also increases with higher earnings.

Because of the grossly unfair tax treatment that earned income receives, coupled with the power of investing in index funds of the whole stock market and the tax benefits one receives for doing so through lower taxes on capital gains, privileged tax treatment for retirement accounts (i.e., 401[k], 403[b], 457, IRA, thrift savings plans, etc.), and other incentives like the Retirement Savings tax credit, relying only on earned income and savings accounts is pretty much hopeless, if your goal is to achieve financial independence. This is why educating yourself (such as by reading Tippyfi) and improving your financial and investing capabilities sooner, rather than later, is critical.

Many people don’t even know where to begin when it comes to enrolling in their employer’s 401(k) or 403(b) programs, let alone choosing their investments. Here, I show an example of how one would do this at my employer, University of Central Florida (UCF).

First, you would seek out this one-page guide from UCF and choose one of three investment providers. I prefer Fidelity, which, like the others, has a portal to aid UCF employees in opening their account. After applying for an account at your chosen provider, at UCF you would complete the Salary Reduction Agreement form and submit it to the HR department. Because UCF is a public school (university), the plan is called a 403(b) instead of a 401(k), but is basically the same. When you put money into such plans, you generally cannot access it until Age 59.5 or older without incurring substantial penalties, so you should pay off high-interest debt and have a substantial emergency fund in an FDIC-insured savings account first.

The form, pictured above, has several options. First, you must decide if you want to make pre-tax (traditional) or post-tax (Roth) contributions, or a combination of the two. Generally, low earners should use post-tax (Roth) contributions because they are in a low tax bracket, while high-earners should use pre-tax (traditional) contributions to reduce their present tax burden. Second, you must choose an investment provider. UCF offers Fidelity, TIAA, and VALIC. Personally, I prefer Fidelity from these three, although I would pick Vanguard if it was available.

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Stocks will eventually crash. The key is to be financially and psychologically prepared to stay invested even when your 401(k) gets chopped in half, your job disappears, and your mortgage goes underwater.

Investing in the whole stock market is a great way to build wealth over the long run. But, just how long is “the long run”? As I am writing this on September 3, 2018, the U.S. stock market hit new all-time highs last week, after a bull market that has lasted, by some accounts, nearly 10 years. Today’s young investors may have no memory of the 2008 financial crisis, where the market declined by about 55%, from its peak on October 9, 2007 to the lowest point on March 9, 2009. For the unlucky who invested at the peak, it took about five years just to get back to even.

Although in the Great Depression, stocks declined by 90% and took 25 years to get back to even, it does not seem a depression of this magnitude will be repeated. However, something less severe than the Great Depression but as bad or worse as the 2008 financial crisis could occur. There is no way to time the market or figure out when it will occur, which is why sound financial advice looks at when you will need to spend your assets and decides the proportion of your assets that should be in stocks—diversified across the whole U.S. or global market.

I am a firm believer in the hypothesis that the duration of your time in the stock market is most important. When comparing investment gains over many years to those over shorter periods, the longer periods show greater gains. However, I have often wrote here that “the long run” is about 15 years or more. In fact, there is a recent example when stocks produced no real returns in a period longer than this: 1966 to 1982. Of course, if you stayed invested since 1966 you have seen tremendous real gains, but for investors then, the pain was profound because interest rates were high; you could earn 7% or even higher per year with 10-year Treasury bonds. As of this writing, the rate is only about 2.9%, which merely keeps pace with inflation.

If you believe the duration of investment is key, then if you receive a windfall, this means you should invest a lump sum proportionate to your asset allocation percentage into the whole stock market, despite the fact that we are historic market highs. At the same time, it is essential to be emotionally, financially, and logistically prepared for a 55% drop in stock valuations.

It is easy to look back on the 2008 financial crisis and ask why people sold their stocks rather than buying more and more. However, many Americans faced a triple whammy of losing their high-paying careers, having their mortgage payment go up and home value plummet, and taking a 40% or larger haircut on their 401(k)s and other investments (if any). Then, many cashed out their investments at fire-sale prices, just to delay foreclosure on their homes. Additionally, no one knew then that the recovery would happen so quickly and powerfully.

Being prepared for a 55% drop means having low overhead, such as a smaller home and older car. It means having a six- or even 12-month emergency fund to cover your living expenses, and enough money in low-risk accounts or investments. At all times, what you want to avoid is being emotionally swayed or financially compelled to liquidate your stocks during a temporary market crash.

Recently, a proposal has been discussed by U.S. Treasury Secretary Mnuchin and President Trump of adjusting capital gains for inflation when it comes to taxation of those gains. This has rightly been criticized as a tax break for the rich, but what has not been widely discussed is the hypocrisy and inequity of not including savings accounts, certificates of deposits (CDs), Treasury bills and bonds, and corporate bonds, which yield “interest” instead of “capital gains,” in the inflation-adjustment proposal.

Although there are no legal restrictions preventing most Americans from investing in stocks (equities), about half do not. Reasons include more pressing financial concerns, fear of loss, and a lack of understanding of how stocks work. Therefore, adjusting capital gains for inflation will mainly be helpful to wealthier Americans.

Capital gains already have numerous tax advantages over earned income, such as:

  • No 15.3% payroll taxes (7.65% employee and 7.65% employer share)
  • If older than one year (long-term), the tax rate is much lower or even 0%
  • Long-term tax rate tops out much lower (20% instead of 37%) for high earners
  • You can choose when to incur capital gains taxes (when to sell)
  • Capital gains tend to be received by high-earners, who gain the most from these advantages because they are in high tax brackets

Presently, interest on savings accounts, CDs, T-bills/bonds, and corporate bonds is taxed at the same rate as earned income and short-term capital gains. Except certain corporate bonds, these types of investments do not yield any capital gains, but rather yield interest only. Thus, none of the above benefits of capitals gains apply. Americans, especially those with lower incomes and net worths, are more likely to put their money in savings accounts, CDs, and Treasury securities rather than stocks. Therefore, they miss out not only on the capital appreciation power of stocks, which is much greater than low-risk assets over the long term; they also miss out on preferential tax treatment that already exists. To add an inflation adjustment on top of this is ridiculous.

Some may quip that stocks do pay something similar to interest, in the form of dividends, which are taxed like earned income and short-term capital gains. This is false; for most “buy and hold” investors in index funds and many individual stocks, the vast majority of dividends are treated as “qualified” dividends which are treated not like interest, but as long-term capital gains. Again, investors in stocks get preferential treatment.

Each year, banks, the U.S. Treasury, and other firms must issue Form 1099-INT to report how much interest income you received in the prior tax year on savings accounts, CDs, T-bills/bonds, et cetera. However, we should not forget that savings accounts typically pay low interest rates—sometimes as little as 0.03% annual percentage yield (APY), with the best accounts paying no more than about 2.0% APY. If we were to adjust savings interest for inflation, which is around 2.4% presently (or 2.9% including food and energy), this would be a loss rather than income! If we adjust capital gains for inflation, shouldn’t we adjust interest too?

Logisitcal challenges aside, if we were to go a step further, offering an above-the-line deduction (like we do with student loan interest) for lost purchasing power on Americans’ savings, capital gains would still be far too advantaged.

Due to the unfairness of how interest is treated, with no consideration of inflation, some have dubbed saving money a suckers’ game. Although a majority of Americans do not understand this, investing, on the other hand, is a winners’ game. The prudent step would be for the government to begin adjusting interest income for inflation but not capital gains. Even then, investors would still be receiving highly preferential treatment as compared with savers.

The above article is also posted on Thripp.com.