A LOT OF INK HAS been spilled over young people’s spending decisions and the impact on retirement savings. Whether it’s a latte or a lunch out, the thinking goes, we all spend money on daily trifles that rob us of a much greater sum in the future. Back in 2019, Suze Orman made headlines when she likened a daily takeout coffee habit to “peeing $1 million down the drain.”
I’m sympathetic to this line of thinking, which is based on solid time value of money principles. For financial planning enthusiasts like me, time value of money calculations can be a lot of fun.
I recall getting my first financial calculator at age 34, which I promptly employed to badger my little cousins. Every time they bought something, I told them how much that money would be worth if they just invested it for 30 years and earned a 10% compounded rate of return.
They rolled their eyes and tuned me out. Turns out it’s hard to get 20-somethings to think about their lives 40 years in the future. Go figure.
But there might be a better way to talk about spending decisions that makes them feel more tangible, no matter how old we are: by talking about the pretax cost of our purchases.
We make purchases with after-tax money. That’s true whether we’re buying breakfasts, taking trips or making mortgage payments. To afford anything we buy, we actually need to earn more money than the sticker price shows. For example, if we pay 30% in federal and state income taxes combined, a $2 coffee costs $2.86 in pretax income, a $10 lunch costs $14.29, and a $50 night on the town costs $71.43.
Once we understand that lesson, we can better compare our spending costs with our pretax income. That’s helpful for those of us who are salaried workers. If you’re like me, you can rattle off your salary without thinking about it, but it’s harder to remember your take-home pay.
Another advantage to this approach: It deals with the reality of current earnings, rather than the distant future. That can be especially helpful for younger workers. A 23-year-old working his first job will likely have a better grasp of the money he’s making today than of his potential net worth in 30 or 40 years.
I don’t have much of a Starbucks habit, but I have other expenses. In July, I traveled to Costa Rica with my fiancée to celebrate our engagement. The trip cost me $2,000 of after-tax money (or 400 lattes, for those counting at home). Assuming a 30% tax rate, I needed to earn some $2,860 in pretax income to pay for the trip.
For illustrative purposes, let’s say my annual salary is $68,600. In that case, the trip to Costa Rica would have cost 1/24 of my yearly earnings, or half a month’s income. If my salary is $34,300, the trip would have cost a month’s income. I likely would have made the trip no matter what. Still, knowing I had to work for an entire month just to cover the cost would have made me consider the expense more carefully.
My belief: We should spend and save money in ways that reflect our values. By grounding these decisions within the real cost of our time and labor, I think we can help others—as well as ourselves—get closer to this ideal.
Matt Trogdon is a financial advisor in Washington, DC, with a special interest in helping Gen X and Gen Y families.
This article first appeared on HumbleDollar. If you’d like to receive the site’s free weekly newsletter, sign up here.
