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.

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As you increase your net worth by paying off high-interest debt, building an emergency savings fund, and investing in stock market index funds via a 401(k) plan, individual retirement arrangement (IRA), taxable brokerage account, and, if applicable, 457 plan and/or health savings account (HSA), you achieve financial freedom and work toward financial independence (FI), which is the ability to live off your portfolio returns without earned income. During this journey, certain types of insurance become unnecessary, while others become critical.

Here I will briefly discuss two types of insurance: automobile (car) insurance and health insurance.

As you accumulate assets, some insurance becomes unnecessary and of poor value—namely, insurance that covers expenses that are assuredly small, in relation to your emergency fund. However, insurance that covers potentially unlimited downside becomes vital, because all your assets could be stripped away without it. (Exceptions exist, such as your retirement accounts and primary residence, but this depends on state law and the circumstances—for instance, in some states your retirement accounts can be seized in a court judgment if you were driving drunk or criminally negligent, but not for other types of at-fault accidents.)

Auto insurance is divided into coverage that pays for damage to your motor vehicle (i.e., collision and comprehensive coverages) and coverage that pays for injuries and damage to others’ motor vehicles and property (i.e., bodily injury liability and property damage liability).

Many people take a loan out to purchase a new car, with little or no savings. They are neither financially independent nor financially free; consequently they need collision, comprehensive, and “gap” coverage. Collision covers damage to your car when you collide with an object, be it another car, a boulder, et cetera (although if another driver was at fault and has coverage, their insurance should pay for your car’s damage). Comprehensive covers damage such as a tree falling on your parked car, hail, or theft. These types of insurance both have deductibles, typically $500, and in a given incident they only pay the amount of damages that exceeds the deductible amount (with some exceptions, such as in Florida, by state law, the deductible for comprehensive is waived for replacing a broken windshield).

Both collision and comprehensive coverages only pay up to the fair market value of your car. This means these insurances do not cover potentially unlimited downside, but rather downside that is capped and predetermined. You can look up the present value of your car using Kelley Blue Book, providing the make, model, year, condition, and mileage. This value, minus your deductible, is approximately the maximum your auto insurance will ever pay out under these aspects of your policy. Consequently, people with plenty of savings typically do not need collision and comprehensive coverage, because they can just pay for auto repairs or a replacement car out-of-pocket.

We often heard about homeowners being “underwater” on their mortgage after the housing crisis, meaning they owed more toward their mortgages than the fair-market value of their homes, despite having paid a down payment and months or years of mortgage payments. This same phenomenon happens on a massive scale with buyers of new cars, because they lose quite a bit of value quickly, causing the amount owed to exceed the car’s value. Thus, people buy “gap” insurance to pay the difference between fair-market value and what they owe, in case their car is totaled. Obviously, having three extra types of insurance (collision, comprehensive, and gap) is costly and perpetuates poverty.

Liability auto insurance, on the other hand, covers potentially unlimited expenses. If you are at-fault in an accident, others’ injuries could cost hundreds of thousands or even millions of dollars. However, you can’t bleed a rock, as the saying goes; people without assets can always declare bankruptcy without losing much besides their credit score, which may already have been damaged to begin with. Although this is socially irresponsible, the more pressing and probable financial need for a low-net-worth individual is repairing or replacing their car, which is why collision, comprehensive, and gap coverage are often prioritized over high bodily injury and property damage liability limits.

Therefore, people approaching FI generally don’t need collision, comprehensive, or gap coverage, but probably should have mid-six-figures of bodily injury protection and $1 million or more in an umbrella policy to cover other scenarios that could destroy their progress toward FI.

A hidden benefit of auto insurance is that your insurer has lawyers and procedures to minimize what they pay out to injured parties, such as pretending the victims of an accident weren’t really hurt that bad, or making lowball offers for immediate payout that the victims will be tempted to take. If you were to self-insure, you would have to hire your own lawyer at great expense to you. However, if your liability limits are low, your insurance company might just pay the limits and walk away, leaving you on the hook to hire a lawyer to settle with the victims for their medical bills, lost wages, pain and suffering, et cetera, which will come directly out of your accumulated savings and investments because you didn’t have adequate insurance.

Health Insurance

Health insurance pays for your personal medical bills—a potentially unlimited expense. Like with auto insurance, low-net-worth individuals can declare bankruptcy to escape medical debts, but someone working toward FI cannot and would not want to do this.

Like with auto insurance, that has the hidden benefit of legal counsel, health insurance has the hidden benefit of negotiated rates. For example, when my grandmother was suffering a brain tumor (may she rest in peace), the hospital transported her by helicopter to another hospital 90 miles away, which was first billed at $47,000, and then reduced to a negotiated rate of $5,300 when Medicare and her insurer paid. An uninsured individual would be billed at $47,000, and could probably negotiate this down quite a bit, but not necessarily all the way to $5,300.

Many types of medical providers expect to work with insured patients, and may be surprised or not even accept patients who do not have insurance. In the United States, people buy or receive health insurance through various “pools,” the largest of which is employer-sponsored insurance, but with the Health Insurance Marketplace, Medicare (for seniors), the Department of Veterans Affairs, and several others providing insurance for millions of people.

In addition to the benefit of negotiated rates, health insurance being tied to your employer offers benefits of economies of scale (they can get a lower rate due to having many employees) and lower taxation. For example, if you pay a premium through your paycheck, this deduction is exempt from payroll and income taxes. Of course, there are also many downsides to the U.S. system.

A great option for those on the path toward FI is a “high deductible” health plan (HDHP). It offers downside that is capped and predetermined—your annual deductible limit, which might be as high as approximately $15,000. Beyond this deductible, it insures against potentially unlimited downside. People on the road to FI need health insurance, for the benefit of negotiated rates and to protect their unsheltered assets from 100% erosion. But, they don’t need a plan that pays for every minor expense. HDHPs also open the opportunity to contribute to an HSA, which is extremely tax-advantaged and can be invested in an index fund of the whole stock market, just like a 401(k), IRA, or taxable brokerage account. Although you may have better insurance via your employer, if an HDHP is a reasonable option, it makes sense for financially free individuals, but not for those who could not pay $15,000 or $30,000 toward their medical bills (don’t forget that your ailment could span two calendar years!).

Overall, auto and health insurance are necessary for both low- and high-net-worth individuals, but different types and levels of coverage are appropriate for each. Low-net-worth individuals always have the “you can’t bleed a rock” factor, so they might insure against small expenses they could not pay out-of-pocket, while leaving the bankruptcy option open for large expenses. Those on the path toward FI have the savings to cover small and moderate expenses, making some types of insurance unnecessary, while the concern of protecting their assets looms large.