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Ben Franklin’s quote is actually underestimating just how good a penny saved really is.
Why is that, you ask?
It’s all a matter of pre-tax and post-tax dollars.
When you earn income (on a W-2, K-1, 1099, whatever basis), and it’s subject to income tax (which is the typical case), then there’s 2 relevant amounts of money. There’s the pre-tax amount (usually considered “gross salary” for a W-2 basis) and then the post-tax amount (federal and state income taxes have been withheld, social security, FICA, etc.). As anyone who’s gotten a regular paycheck can attest, the post-tax numbers are far lower.
Because of this, there’s a couple of things that you quickly learn:
- All things being equal, you want to pay everything you can with pre-tax money since there’s more of it.
- Post-tax money is more “rare”, more valuable, than pre-tax money (to you) and is a more valuable commodity
For instance, say you earned $100 in a paycheck and sending 30% to taxes, it came out to $70 after taxes. If you had a bill for $70 and you could pay it with pre-tax dollars, you’d still have $30 pre-tax dollars left over, which would translate to $21 of post-tax dollars. If you had to pay the bill with post-tax dollars, it would take all $70 and you’d have nothing left over. Trying to spend pre-tax money instead manifests itself in a lot of financial behaviors:
- Setting up a small business to buy things with the company pre-tax dollars
- Saving for retirement with pre-tax dollars via 401k, traditional IRA’s, etc.
- Making donations to registered charities (the donation is deductible)
- Paying a mortgage on your primary home (the interest is deductible)
Some of you may be asking “What do tax deductions have to do with this pre-tax and post-tax concept?” That’s a fair question. When you take deductions for items on your taxes, you are effectively translating those things you paid for with post-tax dollars back to paying them with pre-tax dollars.
For instance, let’s stick with our $100 and 30% tax numbers as an example. If we do nothing with our pre-tax money, the IRS is going to take $30 and leave us with $70. If we put $20 into a 401k the IRS would be taxing $80 instead of $100 and so they’d only get $24 instead of $30. If we then donated $30 to a registered charity, the IRS would only be taxing the $50, which means the IRS is only taking $15 instead of the original $30 they were taking.
Whatever has survived the “we’ll take our slice, thanks” process of taxation by the IRS and your state’s Department of Revenue is a more precious commodity than the pre-tax dollars you earned. Anything you can do to avoid that taxation process on your hard-earned money is a good thing.
If you earn a penny, you’ll actually pocket only some portion of a penny, maybe 0.5-0.7 cents.
If you save a penny, however, you’ll pocket an entire penny.
That’s why a penny saved is far better than a penny earned.
