Don’t think you can retire on modest money? You don’t have to stare down a life sentence of work, you just need to avoid some all too common mistakes.
Reading articles and blog posts online you may be tempted to believe that the biggest scourge threatening your financial goals are subscription boxes, latte consumption, and envy of the Joneses. Having worked within personal finance with people with modest incomes for nearly 20 years, I have learned that there are even more significant threats looking to sabotage your goals.
It is possible to build wealth with a modest income, but it takes a bit more planning and time than a high-income earner. Lower earners need to be as efficient as possible, use a bit of creativity, and avoid these ten common mistakes to become wealthy.
FYI, High-income earners make these mistakes also –, and all should avoid them.
1. Not Optimizing Your Tax Return.
One of the biggest mistakes people with modest incomes make is not creating an income tax plan and tax budget.
The common misconception is that tax planning is only for the “wealthy.” However, tax planning when you have a modest income is critical.
Even if you are in one of the lowest income tax brackets, income taxes can consume 10%, 15% or even more of your income.
For many families, income taxes are their 3rd or 4th largest household expenses. One of the easiest ways to free up money is to create a tax plan.
The IRS offers several tax incentives for individuals and families with a modest income, such as the Retirement Savers Credit, the Premium Tax Credit, the Child Tax Credit, and the Earned Income Tax Credit. Several of these tax credits are refundable. A refundable tax credit can represent free money from the government.
Note: When you qualify for a refundable tax credit, should you manage to reduce your tax bill to zero through other means, then the government could potentially pay you extra money.
Additionally, lowering your taxable income may also help with reducing the amount of income-sensitive student loan repayments, potentially improve with college financial aid for you and your dependents and may reduce the amount of self-employment taxes you may pay.
Should you qualify for several income-sensitive programs, the cumulative effect could be much more significant than you may think. The problem is too many people with modest incomes either put off doing tax planning or wait until tax season (Mid-January to April 15Th) to review their taxes.
Unfortunately, very little can be done after Dec. 31st to reduce taxable income. Engaging in tax planning throughout the year will help you budget for any tax planning measures that are necessary, and strategically time purchases and deductions.
Tax planning does not need to be overly complicated. You can create a tax plan using free online tools. Simply print out a list of any income-sensitive tax incentives you hope to use and compare your anticipated income for the year with the requirements for the program.[Editor’s note: This is an excellent point about working throughout the year to make the most of your tax return the next year. I trade emails with my CPA three or four times per year as we discuss various things I’m doing/considering this year that will impact my taxes next year.]
2. Paying Down Debt Too Aggressively.
We have all seen the articles online: debt is terrible, and loan interest destroys your financial dreams.
Paying off debt is an important goal. However, individuals and families with modest incomes need to be careful not to pay off debt too aggressively. Many financial gurus such as Dave Ramsey or Suze Orman would encourage you to prioritize paying down debt before saving for retirement.
While their hearts are in the right place (they don’t want their audience to become slaves to debt), the math does not always favor aggressive debt pay down. Contributions to retirement accounts could be eligible for employer matching, retirement savers credits, and lower out of pocket health insurance costs.
Recently, I worked with a family who was paying an extra $10k a year on their mortgage and neglecting their 401k. Creating a tax plan revealed that contributing $10k to their 401k would save them over $7,500 in income taxes and health insurance costs. Now they are funding the 401k and using the $7,500 to pay down the mortgage and will be able to retire much sooner.
Paying down debt too aggressively may lead to more debt. Many savers with modest incomes get trapped into the yo-yo diet version of debt paydown. They pay debt too aggressively, saving too little to for emergencies and they are ultimately forced back into debt at the first hiccup.
Many individuals and families would be better served by paying off debt a bit slower. Try to get the lowest payments and interest rate possible. Each month allocate some money to paying down debt and some money towards building emergency funds. As the debt balance declines and your cash reserves grow, then increase the amount you pay on the debt.
3. Not Engaging in Estate Planning.
It seems like we continually see some celebrity in the news who passed away and didn’t…