Why Should You Save Money?

In short, it allows you to enjoy greater security in your life. In this chapter, we will take a look at savings. Why save? When to save? How to save? These are all critical questions, especially if you want to be financially secure in retirement.

Death and taxes are two certainties in life. While we cannot avoid death, we can take steps to minimize our tax liability. In this learning unit, we will also discuss the basics of taxes, how to determine your tax liabilities, and how to reduce, eliminate, or defer your income taxes legally.

In the previous chapter, we talked about developing a budget. When you have a budget surplus, you gain some flexibility with your funds. You can increase your spending, savings, or investment. In this chapter, we will look at savings in more depth, focusing on retirement savings.

Retirement is when you stop selling your labor, and your primary source of income changes from earned income to retirement benefits, personal savings and investments, and Social Security. It is never too early to start planning for retirement so that you can enjoy your golden years without financial worry.

Five Benefits of Savings^[1]

1. It helps in emergencies (e.g., car repair expenses).

2. It cushions against sudden job loss.

3. It helps finance big-ticket purchases (e.g., a new car or a first house) and major life events (e.g., going to college or starting a family).

4. It limits the amount of debt incurred.

5. It helps prepare for retirement.

What Should You Save For?

Savings Rate

The savings rate measures savings over the period in comparison to disposable income.

Savings Instruments

There are many different ways to save your money until you use it. The primary difference is the level of liquidity. Liquidity refers to how easy it is to turn an asset into cash without losing value.^[2]

Table 7: Comparison of Savings Instruments

When Should You Start Saving Money?

The answer is now! The earlier you start saving, the more quickly your money can grow.

How does your money earn money over time?

Money earns money through the magic of compounding. Compounding is the process of earning interest on interest. Watch the video [1:27] to learn more.^[3]

Two Types of Interest

There are two types of interest:

Time To Practice: Simple And Compound Interest

Compounding Periods

Interest can be compounded annually, semi-annually, quarterly, monthly, daily, or on any other basis.^[4] This occurs when the interest is added to the existing balance and the interest begins to earn additional interest.

Table 8: Compounding Periods

If you have an account that pays 12% interest per year, do you receive a single 12% interest payment each year?

• Maybe, maybe not.

• What if you are paid quarterly? You would get four 3% interest payments.

• What if you receive interest once per month?

• What if you receive interest daily?

Interest per period = annual interest rate/frequency

Table 9 shows the interest paid per period if the annual interest rate is 12%.

Table 9: Interest Paid per Period (12% rate)

Rule of 70

The Rule of 70 is a mathematical rule of thumb that can be applied to the growth rate of anything.

If you divide the growth rate into 70, you get the approximate amount of time it takes for that thing to double in size. For example, to double $1,000 at a 10% annual interest rate, you will need about 70 ÷ 10 = 7 years.

Example of the Rule of 70

Mel has $500 in an account that pays 3.5% interest annually. Use the Rule of 70 to approximate how long it will take Mel to have $1,000, $2,000, and $4,000, respectively.

1. From $500 to $1,000?

    

   $$\text{Time to double}=\frac{70}{\text{Growth rate}}=\frac{70}{3.5}=20\text{years}$$ 

2. From $1,000 to $2,000?

    

   $$\text{Time to double}=\frac{70}{\text{Growth rate}}=\frac{70}{3.5}=20\text{years}$$ 

3. It takes Mel about 40 years to grow the money from $500 to $2,000.

Why Pay Taxes?

Taxes are mandatory contributions levied on individuals or corporations by a government entity—whether local, regional, or national.^[5] Taxes provide revenue for governments to fund essential services—national defense, highways, police, a justice system—that benefit all citizens. Taxes also fund programs and services that benefit only certain citizens, such as Medicare, job training, schools, and parks.^[6]

Types of Taxes

To learn more, refer to your textbook, Personal Finance: Chapter 6.1 , or view the article, Types of Taxes.

Income Taxes

Most individuals pay federal, state, and local income taxes.

Federal Taxes

The Internal Revenue Service (IRS) administers the federal tax system. The tax year for federal income tax ends on Dec. 31. If you earn income, you must file a Form 1040, 1040A, or 1040EZ to determine your tax liability by April 15 of each year.

Additional information on federal taxes is available by viewing these resources.

• To learn more about IRS 1040 form, view What Is an IRS 1040 Form? 

• To learn how to file your 1040 form, visit the IRS webpage, How to File
• To estimate your tax liability and tax refund, if applicable, visit TurboTax
• Watch this video from the IRS on How to Pay Your Taxes [1:51 minutes]

States Taxes

As of 2022, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming are the only states that do not have a state individual income tax.^[7]

Local Taxes

About a third of all states allow their counties, municipalities, and other local jurisdictions to impose an income tax. Tax rates are often lower than at the federal or state levels.

As of 2022, states with local income taxes are Alabama, Colorado, Delaware, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, and West Virginia.^[8]

Tax Liability

Progressive Tax

Income tax is usually a progressive tax. The higher the taxable income, the greater the tax rate. Those income categories are called tax brackets.

There are seven federal income tax brackets for the 2023-2024 season: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your filing status (single, married filing separately, married filing jointly, etc.) and taxable income determine your bracket.

Table 10: Income Tax Brackets in 2023 (Single Filing Status)^[9]

Determine Your Preliminary Tax Liability

1. Determine filing status (i.e., single, married filing separately, married filing jointly, etc.)

2. Refer to the appropriate tax brackets and find your tax on base and tax rate.

3. Apply the formula: Preliminary tax liability = Tax on base + Tax rate on excess × (Taxable income − Base)

Example—Determine Billy’s Preliminary Tax Liability

1. Billy’s filing status = Single and his taxable income = $31,000.

2. Using the table above, his taxable income falls into the second tax bracket:  tax on base = $1,100 and tax rate on excess = 12%

3. Preliminary tax liability = $1,100 plus 12% of the excess over $11,000

Time to Practice: Preliminary Tax Liability

Let’s help Alice determine her preliminary tax liability. Alice’s taxable income is $54,725.

She is married filing separately. Here are the relevant tax brackets for her filing:

Table 11: 2023 Married Filing Separately Tax Brackets^[10]

Using the information provided above, help Alice figure out her preliminary tax liability.

Income Tax Planning

There is no obligation to pay any more in taxes than legally required. Tax planning seeks legal ways to reduce, eliminate, or defer income taxes. To achieve this goal, you can 1) reduce taxable income, 2) apply for tax credit, or combine these two.

Reducing Taxable Income

Your income tax is calculated based on your taxable income. Reducing your taxable income, not your total income, is the key to paying less income tax.

We must differentiate between total income, gross income, adjusted gross income, and taxable income.

Deductions

Deductions: Standard deduction and itemized deduction. The IRS adjusts the standard deduction for inflation for each tax year.

Table 12: Standard Deduction Amounts for 2023 Taxes

The standard deduction is the simplest way to reduce your taxable income on your tax return. You simply claim a flat dollar amount determined by the IRS.

Here is what that means: If you earned $75,000 in 2023 and file as a single taxpayer, taking the standard deduction of $13,850 will reduce your taxable income to $61,150. Use the itemized deduction only when it is greater than the standard deduction.

Exemptions

Personal exemptions are based on the number of people supported by the taxpayer’s income—one exemption each for the taxpayer, the spouse, and each dependent child. In 2017, for example, the exemption was $4,050 per person in the household. Personal exemptions have been eliminated beginning after December 31, 2017, and before January 1, 2026.^[11]

Reduce Your Preliminary Tax Liability

Six Steps To Calculate Your Final Tax Liability

Strategies To Reduce Income Taxes

Reduce taxable income through your employer.

• Premium health insurance plan

• Transportation reimbursement plan

• Flexible Spending Account (FSA)

• 401(k) retirement plan—Contribute to your employer-sponsored 401(k) plan at least up to the employer’s matching contribution amount.

Make tax-sheltered investments.^[12]

A tax shelter is a place to legally store assets so that current tax liabilities are minimized. A tax shelter may permanently reduce the tax amount or simply defer the taxes owed to a future period. Returns of tax-sheltered investments are tax-advantaged.

Examples of tax-sheltered investments:

• Traditional IRA

• Section 529 college saving plan

• Government savings bonds

• Capital gains on housing

How Tax Planning Fits Within Your Financial Plan

Ask yourself the following questions:

• What tax savings are currently available to me?

• How can I increase my tax savings in the future?

• Should I increase or decrease the amount of my withholding?

• What records should I keep?

Table 13: Financial Plan Example

Why Should You Start Saving for Retirement Early? The Magic of Compounding

Why Should You Start Saving for Retirement Early? To Reduce or Defer Income Tax

We’ll look at two options to reduce or defer income tax: employer-sponsored retirement plans and individual retirement accounts (IRAs).

Employer-Sponsored Retirement Plans

Examples of employer-sponsored retirement plans that we’ll explore include:

• 401(k) plan:

  • Traditional 401(k)

  • Roth 401(k)

• 403(b) plan

• Simplified Employee Plan (SEP)

• Savings Incentive Match Plan for Employees(SIMPLE) Plan

• 457 plan. Visit 457 Plan to learn more.

Retirement Plans for the Self-Employed

Examples of retirement plans for the self-employed that we’ll explore include:

• Keogh Plan: contribution from pre-tax income. To learn more about the Keogh Plan, read Keogh Plan: Definition Types, Advantages & Disadvantages .

• Individual Retirement Account (IRA)

• Traditional IRA

• Roth IRA

• Simplified Employee Plan (SEP) IRA. To learn more about the SEP, read Simplified Employee Pension (SEP) IRA: What It Is, How It Works 

How Much Do You Need To Retire?