Building Wealth from Zero Part 2: Taxes and Paying Student Loans

Wealth Building Aug 06, 2020

The focus of this part is understanding taxes and the different approaches to paying off student loans. Student loans are simple for the most part - just pay them consistently on time and they will eventually go away. Taxes are tricky, but must be understood to build wealth. We always hear about how the wealthy evade taxes legally. At the very least, we need to equip ourselves with minimal tax knowledge.

As a reminder, here are the average starting point we agreed on in Part 1:

Age: 25
Starting Salary: $50,000
Assets: $0
Student Debt: $30,000 with 5% fixed interest rate over 10 year period
Net Worth: -$30,000

File Your Own Taxes

We should all file our own taxes. The primary purpose is to understand how our income is taxed and the second purpose is to save money (accountants cost money).

I prefer to use tax software to guide my tax filing such as TurboTax , H&R Block,  and TaxAct. Most tax software have a free version as well. Be sure to check out the official IRS website for free tax software if you make $69,000 or less.

*At the time of this post, I am not sponsored by any of the above mentioned businesses.

Understanding How Our Incomes are Taxed

There is a misconception about how incomes are taxed that if you make too much money, then you will be taxed at a higher rate so it might be a good idea to skip that raise.

It is a terrible idea and I cringe at the fact that people may have passed on raises because of this misconception.

It is true that our incomes are taxed at specific brackets and higher incomes in those brackets are taxed at a higher rate. The truth is that only part of your income is taxed at a specific rate and NOT your entire income. Let’s look at the income tax chart from the IRS website.

2020 Tax Brackets for Single Individual

Notice how it mentions "... 22% of the excess over ...". Below is a calculation to demonstrate what the IRS means by this phrase.

2020 Tax Brackets for Single Individual on $50,000 Salary

When we receive a raise only the money over the income bracket will be taxed at the higher rate. For example, if we look at the chart on the $40,126 to $85,525 income bracket, only $9,875 is taxed at 22% and NOT your entire $50,000 salary. So go ahead and take the higher raise!

In the above calculation, we are skipping state and local taxes and deductions, which is income that is exempt from taxes.

Be sure to read up taxes on IRS.gov especially if you are confused about definition or terminology (or shoot me an email!).

Take Home Pay

Your take home pay is one of the most important numbers because it is the actual amount of money being deposited into your bank account. Your budget will start from this number.

Smart Asset Paycheck Calculator

According to the Smart Asset calculator, our take-home pay each month is $3,096 ($1,548 * 2 semi-monthly paychecks). The take home pay is not complete and should be less because we are leaving out insurance and retirement benefits.

For the sake of simplicity, lets say your budget each month is $3,096.

Paying Off Student Loans

A portion of this $3,096 will go toward our $30,000 student loans each month.

Bankrate Student Loan Calculator

According to Bankrate, we would have to make $318.20 monthly payments for 10 years. The first thing to notice is the Total Interest Paid of $8,183.59. The interest for any debt is how much you are paying on top of the original loan and how lenders make money.

If we scroll a bit lower, we will see the amortization schedule which will help us visualize how each monthly payment is broken down between principal and interest.

Scroll down on the Bankrate Student Loan Calculator (Top 4 Rows)

Our earlier payments will have more interest and less principal. As we progress, we can see the principal increase and interest decrease each month. Keep in mind, we are still paying $318.20 each month.

Last 6 rows of Amortization Schedule

In the last six payments, we are mostly paying off the principal and the interest is now less than $10. Most debt is structured in this fashion where we pay loads of interest in the beginning and most of the principal towards the end of the debt period.

10 years... that is a long time. We have other goals in life such as financing a car, starting a business, purchasing a home, etc. How can we pay off our debt earlier?

The solution is to simply pay more each month. All additional payments on top of $318.20 each month will go directly to the principal. What happens if we pay $100.00 more each month?

We shaved off almost 3 years!

If we decided to pay $418.20 each month then we will have paid off our student loans within 7 years instead of the initial 10 years. Also note, that instead of paying $8,183.59 in interest, we only paid $5,715.63. We saved a lot of money and time in the short run for just $100.00 more each month.

To keep calculations simple, we will stick with $318.20 for now but just be aware about the option to paying off debt early.

More Financial Information for our Imaginary Wealth Builder

Age: 25
Starting Salary: $50,000
Monthly Take Home Pay:  $3,096
Assets: $0
Student Debt: $30,000 with 5% fixed interest rate over 10 year period
Student Debt Monthly Payment: $318.20
Net Worth: -$30,000

Next up we will dive into the world of investing and how we can generate growth while in debt and why we might not want to pay off our student debt as early as possible.


Cover Image Credit: The New York Public Library

DISCLAIMER: This blog references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. This blog makes no representations as to accuracy, completeness, currentness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis. Please do your own comprehensive research before investing in anything.

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Alan Chen

Hi! One day, I will build a technology company that will change the world. Right now my focus is teaching personal finance. Now that you know a little about me, feel free to reach out and chat!

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