CHAPTER FIVE
W-2s, W-WHAT?
School’s out and it’s not just for summer. No more playing dress-up on a Tuesday night or having bourbon for breakfast. No more classroom talks that inspire heated discourse, but have no true consequences. No more meal plans. No more class plans. No more plans, unless you make them for yourself. Some would say that it’s time to “adult.”
Not me. I find the term “adulting” pretty ridiculous. People love to slap it on tasks that any 20- or 30-something-year-old should be able to handle. You made an omelet for breakfast? Adulting. You paid a parking ticket? On time? Adulting. You went to a BYOB paint night instead of your regular jaunt? Hashtag adulting.
Yes, you can do these things when you’re an adult. You can also probably do them when you aren’t, because they aren’t the things that make you one.
Because you took the time to become honest with yourself, selected the right college based on your funding and goals, became an early master of cash flow, and selected the right repayment plan for your student loans, you already started becoming an adult long ago. And if you didn’t, this is the perfect time to adopt the disciplined mindset and techniques of the past several chapters and have a fresh start as you begin your career.
The working world can be exciting, but nerve-racking; this is especially so for Millennials, who are faced with the challenges of an unchartered labor environment. Because things only get more complicated as you move forward in your career and life, having a solid foundation from this point on will pay off in a big way.
We are going to revisit cash management, talk taxes, study employee benefits, and introduce the concept of investments by learning when it’s appropriate to make them. To tailor this toward our reality, I will cover these topics for both corporate employees and self-employed entrepreneurs like me.
CASH FLOW REVISITED
Starting your career is a huge accomplishment. It might be the first time the money in your pocket doesn’t come from your parents, scholarships, or student loans. Your main source of income now derives from a salary paid by your corporate employer or from the revenue you generate from your business’s goods or services. It may feel different than before, and it should—you’re earning every dollar. What this money means to your life requires you to look at the concept of cash flow again.
The mechanics of cash flow that you started mastering in college are pretty much the same now. The main difference is that you aren’t backing in to your expenses to figure out how much you need to live. You are going to use your earned income to back out to what you have available to either spend or save each month.
Simply put, if you’re earning a salary of $45,000 per year, you have that money to make it all work. If you spend more than what you’re making, you will end up either taking on debt or needing to make sacrifices. I think we can all agree that taking on debt, outside of buying a home or starting a business, is not how we achieve GTL (Great Things in Life). No sir, I don’t like it.
Remember the cash flow formula?
Income − Expenses = Savings (or Deficit)
That remains the same, but a few key details have changed. See the following table:
|
Income |
− |
Taxes |
− |
Fixed Expenses |
− |
Variable Expenses |
= |
Savings or Deficit |
Break expenses into three categories: taxes, fixed expenses, and variable expenses. We discussed fixed and variable expenses back in Chapter 3 and listed examples, but now we’ve added taxes as a separate expense item because of how significant a role they now play in cash flow. For those who worked during their college years, you might already be familiar with how taxes affect your spending power (more on this in a minute).
Are the numbers tighter than you’d like? You may not earn enough income to cover the lifestyle you used to enjoy living on someone else’s dime. But being uncomfortable is normal. Not all jobs or opportunities are going to provide what you need to live the same way you’re used to. However, this doesn’t necessarily mean you can’t accept the job. If you really want the job more than you like your lifestyle, you can probably find a way to make it work. Whether that’s living at home, sharing an apartment with three roommates, or convincing your family to invest in your pursuit of professional growth is for you to figure out. Sacrifice is a huge part of adjusting to the working world. This will be just the first of many times.
One way to see if your budget works is by tracking the month-end balance of your checking account. If you’re on budget, you should have roughly the same amount of cash in there each month. But try to see where you end up after three or four months. Things come up, and checking your budget after only one month often doesn’t say it all about your spending habits.
TAXES
Taxes are people’s most hated expense. They can have a dramatic impact on how much money you take home with each paycheck. When they aren’t properly planned for, they can cause serious cash flow issues, to say the least. Therefore, it’s essential for you to have a basic understanding of how they work.
Money set aside for future tax collections is called withholding. You’ll be doing it your entire working life.
For those working as an employee (also known as a “statutory employee”), you are going to complete a tax form called a W-4 upon being hired. The W-4 is a worksheet designed to help you decide how much money should be taken from your paycheck for federal taxes. In general, this worksheet does a decent job of guiding you to a result that will have you withholding enough money from each paycheck so that you don’t owe the government an exorbitant amount of money when taxes are due. And FYI, they’re due on April 15th, so you might as well set an annual reminder on your smartphone now.
Depending on where you live, you might need to withhold for state and local income taxes, too. Each state will have its own version of a W-4 to help you determine the proper amount. In addition to federal, state, and local taxes being withheld, you will also pay into two federal entitlement programs that you may have heard of: Social Security and Medicare (FICA).
For you freelancers and entrepreneurs, withholding for taxes works differently because you’re technically not on payroll. You are your own employer, an independent contractor if you will, and for you, withholding for taxes is on your shoulders.
Overseeing your tax withholding can be considered more flexible for both cash flow and tax planning because you can deduct various business-related expenses. But on the other hand, it can be dangerous for those who don’t know what they are doing. Also, self-employed individuals may be responsible for additional taxes just for being self-employed (called a “self-employment tax”—very original). These taxes can be found at the federal, state, and local levels and they need to be accounted for just the same.
There are so many factors that play into calculating taxes. Especially for the self-employed, I am a huge advocate of hiring a trusted tax professional, preferably a certified public accountant (CPA), who can help you understand your own unique tax situation and guide you on how to best withhold throughout the year. However, if you would rather do it on your own, you can use any number of tax calculators. I like the Salary Calculator on PaycheckCity.com for calculating your tax withholding and TurboTax for filing your taxes. Once you have calculated your estimated tax expense, you can plug that into the cash flow formula.
Before we leave taxes behind, let’s touch on what happens when you withhold too much or too little. A tax refund is the result of withholding too much money for taxes. On its face, the idea of getting money back from the government sounds great, but in all actuality it’s not good at all. You are getting your own money back, just at a later point in time. Technically, you loaned the government money you could have used or saved throughout the year at a rate of zero percent. How generous of you!
Think about it this way: you don’t see the federal government giving you a zero percent interest loan for your education, do you? Nope. It’s not found money; it’s your money.
The flip side of paying taxes is owing them. As you may have guessed, this is the result of not having withheld enough for taxes throughout the year. Being surprised that you owe the government a chunk of money is far from good. There is an exception, though. If you did a stellar job with tax planning (or hired a CPA that’s worth their weight in abacuses), you could have anticipated that there would be a tax payment waiting for you, allowing you to put that money aside throughout the year. Preparedness is key. Improper tax planning, however, could hit your savings hard or get you in trouble with the IRS. Both are disruptive to achieving your financial goals and are a total buzzkill on your life.
Since when is zero a perfect score? With taxes, that’s when. Neither owing too much money nor getting too much of your own money back is ideal. The goal is to understand what you’re paying Uncle Sam, while receiving nothing back (or paying little to nothing) each year.
EMPLOYEE BENEFITS
Benefits are perks that often come with working as a corporate employee. Employee benefits range far and wide, but their chief purpose is to retain you as talent, which allows your employer to remain competitive in your industry.
The most common benefits—or “core benefits” as I like to call them—include access to health, life, and disability insurance, as well as a retirement plan, such as a 401(k) or 403(b). Paid time off, transit stipends, flexible savings accounts, dental and vision insurance, maternity/paternity leave, free or reduced-cost dining, and child care facilities are some examples of additional employee benefits, but some of these are not the norm. Hey, not everyone can work at the Googleplex and get free gourmet meals!
Here, we will focus on core benefits alone.
Health Insurance
The most coveted employer benefit is access to health insurance. At its most basic level, health insurance provides you with access to doctors, treatment, and prescriptions at a lower cost. Being insured is all but necessary, because the cost of a major medical procedure without coverage could be financially devastating. We’re talking a difference in the tens of thousands of dollars for even a one-night stay at the hospital. Although universal medical insurance coverage is at the forefront of American politics and currently available for purchase via the public option, it is expensive no matter how you slice it.1 Therefore, when your employer is offering to subsidize all or part of the premium for a decent health insurance plan, it’s a big incentive.
Your employer might have several plans to choose from, all with different prices, features, and limits. This book can’t account for the design and cost of all plans out there, but by breaking down the main components, you will be able to make an informed decision about which plan is right for you.
And now, a thrilling course in healthcare terminology.2
Premiums: These are the payments you make each month, or with each paycheck, to be a part of the plan. Your employer will provide you with the per-month or per-pay-period cost for any plan offered and tell you how much they will pick up. Most employers will deduct health insurance premiums from your paycheck on a pre-tax basis, meaning you won’t pay tax on the portion of your income that was used to pay for the premium. Consider this another bonus for you.
Deductible: Some plans also require you to front a certain amount of money for medical services before your insurer pays anything. Deductibles are based on a certain time period—usually one year. For example, if your plan has a $5,000 deductible, you will need to first pay $5,000 in qualifying healthcare costs before your plan will pay for anything.
Coinsurance: This is a percentage of what you must pay for healthcare costs after you meet your deductible. Consider yourself the “coinsurer” of all your healthcare risks. Plans with coinsurance typically cover 80–90 percent of eligible costs after the deductible has been satisfied. For example, let’s assume you already satisfied the $5,000 deductible. If your plan has 20 percent in coinsurance, and you incurred another $1,000 in medical expenses, you would be responsible for paying $200.
Copayment (Copay): This is an upfront payment made when you receive healthcare-related services. For example, if you are visiting a specialist, like a dermatologist, you might have to pay a flat amount, say $50, in connection with that appointment. This isn’t the same as coinsurance. Often, plans feature one or the other.
In and Out of Network: Your plan could be defined or limited by doctors and facilities that are associated with your plan’s network. Generally, you will receive less generous coverage for having services outside of your network. There could be a separate deductible for these services, or simply no coverage at all. It’s a good idea to see what healthcare providers are in-network before selecting a plan. I’m a fan of plans that offer some sort of out-of-network coverage, even if it’s minimal. So, if you have a skiing accident on vacation and are taken to a remote hospital, the bill might not be pretty, but with out-of-network coverage, at least it won’t be devastating.
Out-of-Pocket Maximum: You’re probably not having a good year if you’ve reached your out-of-pocket maximum. This is the most money you can possibly spend before your insurance picks up 100 percent of covered costs. Generally, this does not include premiums, but it does include just about everything else. For example, it’s January 2nd, and you broke your arm breakdancing on New Year’s Eve.3 The medical bills for putting your limb back together totaled $20,000, and they were all in-network. If your deductible is $5,000, your coinsurance is 20 percent, and your out-of-pocket maximum is $7,500, the most you are going to pay is $7,500. Any covered in-network medical expenses for the rest of the year will be 100 percent covered by your plan. That’s called a silver lining.
There are dozens of other terms related to health insurance, but knowing the ones just discussed will help you understand the gibberish of choosing a medical plan. Ultimately, you’ll need to evaluate your overall healthcare needs alongside your cash flow to choose a plan. For those who are in tip-top shape and rarely see doctors beyond an annual physical, maybe a high-deductible plan with low premiums would be a risk worth taking for you. Indeed, it costs less if nothing happens. However, if you’re prone to getting sick, have chronic illnesses, are super clumsy, or just love searching WebMD and seeing specialists, perhaps there’s more economic value to choosing a plan with higher premiums and a lower deductible and coinsurance. Your goal is to find the option that best fits your healthcare needs while also keeping costs in mind.
Now, for the self-employed peeps, things are a little more complicated with your health insurance coverage. Your primary options are buying private coverage, purchasing a plan through the public option if one is available to you, joining your spouse or domestic partner’s plan, or if possible, remaining on your parent’s health insurance, which is currently permitted through age 26.
Unfortunately, in many instances, coverage for the self-employed (or unemployed) is more expensive and less comprehensive for the same money as those receiving health insurance through their employer. However, I suggest you look into joining professional associations within your field, many of which offer their members pooled access to benefits such as health insurance. The membership dues might be worth it.
Lastly, some coverage—no matter how poor—is always better than none. No one is invincible and accidents happen. Remember that, next time you bust a move on New Year’s Eve.
Disability Insurance
At this stage in your life, one of your most important assets is your ability to earn income. Without this ability, it’s impossible to achieve GTL. Therefore, a quintessential core benefit is group disability insurance.
Should you be unable to perform the duties of your job due to—you guessed it—disability, this type of insurance coverage provides a percentage of your income as a monthly benefit. Disability insurance comes in two varieties: short-term and long-term, each covering a certain period. Typically, short-term disability will provide you with 100 percent of your monthly wages for between two weeks and one year, depending on the plan. After that, long-term disability will generally cover amounts as high as 60 percent of your wages through age 65. For this section, we’re going to focus on long-term disability insurance.
I highly support enrolling in any employer-provided group disability insurance. It’s generally much cheaper than purchasing an individual policy on the open market. If these benefits are available through your workplace, learn more about their cost and then strongly consider enrolling as soon as possible. It’s often too good of a protection planning opportunity to pass up.
Please note one detail. Pay close attention to whether your premiums for group coverage are coming out of each paycheck on an after-tax basis. (They generally are, but I’ve seen some cases where they are being paid pre-tax.) You will want to pay for any group disability coverage with after-tax payroll deductions, because if you ever need to collect, you would then receive that benefit tax-free. There’s a big difference between 60 percent of your income and 60 percent of your income after taxes. Check your pay stub and if it isn’t clear, reach out to human resources for clarification.
Once again, self-employed hustlers must fend for themselves with disability insurance coverage. As I mentioned before, disability insurance isn’t cheap for individuals. The premiums for this kind of coverage are determined by an evaluation of your health and income through a process called underwriting. The insurance carrier collects personal and financial information through your application, medical records, blood and urine samples, and other physical measurements to determine your eligibility for coverage. It’s a complicated web, so I recommend that you consult a trusted financial or insurance professional to provide you with quotes and guidance for coverage options and their associated features.
There are policies of all shapes and sizes, so it is important to understand what’s out there. Should you head down the path of applying for individual coverage, know there are two general categories of disability insurance policies. They are any occupation (called “any-occ”) and own occupation (“own-occ”). Any-occ policies will not pay a benefit if you become disabled and can perform any other job that is not your own. So, if you can flip a burger but not write computer code (your real talent), then no benefit for you. Ouch! Own-occ policies, however, will pay a disability benefit if you cannot perform your specific job function. Although these policies are more expensive, I find them to be worth the extra premium bucks if you can afford it. Individual policies are also portable; meaning, if you leave your job, the coverage will come with you if you continue to pay your premiums.
Again, professional associations can be a valuable resource for those not offered disability insurance through their employer or those who cannot afford or qualify for an individual policy. Also, some states like New York, New Jersey, and California have mandatory disability programs that residents pay into. Although these plans can be helpful if you become disabled, they are usually insufficient to cover most your expenses. Then again, something is better than nothing, so it’s worth learning more about your state’s coverage.
Disability insurance, like all insurance, is a way to reduce the fallout after something bad happens. This discussion is not meant to scare you (many advisors and agents will try to), but rather allow you to think about the risks we face every day and how to lessen them in a cost-effective way. We are all entitled to our own opinions regarding the likelihood of becoming sick or disabled.
Life Insurance
The last of our core insurance benefits is life insurance. Life insurance provides a death benefit to a person(s) or entity of your choice, called a beneficiary. Life insurance is primarily designed to replace some or all the income or “value” associated with the loss of life. Death benefits range from the hundreds of thousands to millions of dollars. Many employers provide a free basic benefit of $50,000, with the ability to purchase more in multiples of your salary. But let’s stop here, because we will discuss this more later.
Retirement Plans
The purpose of any retirement plan is to allow you to invest a portion of your income now, so that you can access it in later years. There are certain tax benefits associated with the money you contribute, as well as potential chances to receive free money in the form of employer contributions. I will outline the main types of employer-sponsored plans available, how they work, the various incentives that come with them, and what’s available for people without access to them.
There are three main types of employer-provided retirement plans. You may have heard of a 401(k), which is a tax-qualified, defined contribution retirement plan provided by a for-profit employer. What did he just say? “Tax qualified” means that there are tax benefits associated with participating in the plan, whereas “defined contribution” refers to the fact that you, the plan participant, defines how much goes into the plan, up to certain limits. In 2017, the most an employee under 50 can contribute to any one of these plans is $18,000 per year.
There’s also a version of this plan for employees of nonprofits called a 403(b) and one for governmental employees called a 457 plan.4
There are a few features that make these plans so attractive. For one, they have high contribution limits; meaning, you can put a lot of money into them each year. They are also “tax advantaged”; meaning, the money you put in can be contributed on either a pre-tax basis or after-tax basis, and it can grow tax-deferred.
For example, if you contribute 10 percent of a $100,000 salary ($10,000), you would be able to exclude that $10,000 from your taxable income. Moreover, the money in your retirement plan grows tax-deferred. Any income generated—such as the payment of dividends and interest or realized gains from the sale of investments—will not be taxed if that money remains in the plan. According to IRS rules, when you reach age 59.5, you can access this money without penalty, but when you do, distributions from the plan will be treated as taxable income. Not having to pay taxes on the plan’s growth and income until distribution allows it to grow much more quickly than a nonretirement investment account when invested through a long period. This is why these types of retirement plans are so hot right now and always.
If you are eligible to participate, you will need to complete some enrollment paperwork or enroll online. During the enrollment process, you will be able to select the percentage of your income you wish to contribute to the plan and choose from the investment choices available in the plan. However, before contributing anything, make sure that you can afford to put money into your plan within the context of your broader goals. Sure, saving for financial independence can be a great idea, but is it a priority? Only you can answer that.
After-tax contributions, otherwise known as Roth contributions, work a little differently. Unlike their before-tax counterpart, these contributions are taxed as income in the year that they are made; however, they also grow tax-deferred. The big difference is that upon distribution after age 59.5, the money comes out tax-free.
So, which type of contribution is better to make? Well, that’s tough to say, but it comes down to where you think tax rates will be in the future, and whether you think you’ll be generating more taxable income now or in the future.
Because this is where your mind is at, right? You just wrapped your head around accepting your first job, and now you’ve got to become a fortuneteller, too?
As it’s almost impossible to predict what tax rates will look like or what your income will be decades down the road, it might be a good idea to have a combination of both contributions, if possible. Then, you don’t have to look too hard into the crystal ball.
A very desirable feature of employer-given retirement plans is the ability to receive additional contributions at the employer’s discretion. We call this FREE MONEY! Cue the marching band! You can receive these contributions as a match to what you put in, up to a certain limit. Or you might receive an automatic contribution, generally 3 or 4 percent, just for participating in the plan.
If you are eligible to receive an employer contribution, you should jump on that free money, even if it means contributing a small portion of your salary. For example, a typical matching contribution could be something like “100 percent of your first 3 percent contributed.” So, if you contribute at least 3 percent to your plan, you’re going to receive another 3 percent contribution from your employer. It is important to note that some employer contributions can have a vesting schedule (or waiting period) associated with them. This protects an employer from your decision to scoot after you’ve gotten your free dough. Vesting schedules come in a few varieties and can last as long as five years, so be sure to see if one applies to your benefit.
For those without access to an employer-sponsored retirement plan, there are retirement savings options for you, too. If you are a statutory employee without access to a work-sponsored plan, you can contribute to a Traditional IRA or a Roth IRA, up to certain income limitations (for Roth). In 2017, individuals under 50 can contribute up to $5,500 to a Traditional or Roth Individual Retirement Account (IRA). It’s not that much compared to employer-provided retirement plans, but something is better than nothing. You already know the difference between contributing pre-tax and after-tax dollars, so those same rules apply as discussed earlier.
Things always get more complex with my self-employed hustlers. For you, there are several options available, from IRAs, to setting up your own retirement plan such as a 401(k). However, one specific retirement plan worth mentioning is a Simplified Employee Pension Individual Retirement Account, known as a SEP IRA.
The SEP IRA is one of the most cost-effective ways for a self-employed person with no employees to save for retirement beyond the limits of a Traditional IRA or Roth IRA. In 2017, you can contribute to a SEP IRA slightly less than 20 percent of your net profit (gross income less qualified business expenses) up to $54,000. So, for self-employed individuals with large net incomes, this would be an excellent way to save for retirement. Contributions to SEP IRAs are always pre-tax. There is no Roth option available.
Opening a retirement account of any kind or establishing your own retirement plan can be done with the help of a financial advisor, or on your own through any number of financial companies specializing in this space. It may not be too difficult, but it is time-consuming.
INVESTMENTS? NOT SO FAST (THE CASH RESERVE)
When I tell some people that I’m a financial advisor, they like to ask, “So what’s a good investment these days?”
A little piece of me dies inside every time.
Although innocent, this question flies in the face of almost everything we’ve discussed so far. Why is this person investing money? What is he investing for? Does he think I pick stocks for a living? What is this, Boiler Room? I wonder if he has even earned the right to invest.
Wait. What was that?
You need to earn the right to invest. That’s right. There are benchmarks you must hit before even discussing investments. First, you master your cash flow. If you discover you are saving money each month, that’s great. Still, before you can earn the right to invest, you must almost always establish a cash reserve. Here’s why.
I define a cash reserve as having three-to-six months of your living expenses (fixed plus variable expenses) in cash. By now, you should have an idea of those living expenses, so these numbers should not be hard to figure out. We build cash reserves so that we can protect ourselves from emergencies without having to take on debt or invade savings earmarked for other goals. We also build cash reserves to take advantage of unforeseen opportunities. The cash reserve is your cushion if things come up, because they do.
Should you allocate all your available savings toward a cash reserve before doing anything? Not necessarily. The right answer is a bit subjective, which is why we spent time on goal priority and need to revisit it here once again.
Let’s assume that your budget reveals you can save $100/month, and this is after you can make at least the interest payments on your student loans. Besides taking advantage of matching retirement plan contributions (get the free money no matter what!), you’re going to have to decide where that next dollar goes. Because we technically added a new goal to the mix—the cash reserve—you need to ask yourself, how much of a safety net do you want to have?
Again, it’s goal priority, baby. You can make changes along the way when you start getting a feel for things. As you settle into your career or business, you might feel more confident and think that carrying a smaller cash reserve is okay. Or perhaps if you are nervous about job security, you will want to have more cash on hand. It’s a constant evaluation that’s always changing.
We covered a lot of information here, but most of it assumed that you had a job. I don’t want an overarching piece of advice to get lost in the details: don’t give up. If today’s unchartered labor environment is preventing you from accessing your most desired career off the bat, it’s okay. A diploma is no longer a meal ticket. You must rely on your creativity, agility, and flexibility to craft your own success like never before.
Just keep pushing, and do whatever you must do to stay empowered. You only slip deeper into the problem when you start feeling helpless and sorry for yourself. There’s no shame in shacking up with your parents in your bright blue childhood bedroom (ahem), as long as you stay focused on your pursuit.
Nothing worth doing is easy.
Do you feel it yet? At this point, the concepts you are learning are building upon one another more and more: identifying your goals; exploring self-honesty; financing your education; managing your cash; and making smart decisions about the income and benefits that come along with employment.