One of the difficult things in personal finance is linking our pre-tax wages with our post-tax expenditures.  For instance, we tend to think of our stated salary of, say $30,000, in the same vein as the $30,000 car that we buy at the local car dealership.  However, because of the effect of taxes, these amounts are actually not that comparable.

If our total tax rate is 20%, that $30,000 salary only allows us to take home $24,000, which will be $6,000 short of the amount needed to buy the car.  Looking from the other perspective, at the same 20% tax rate, the $30,000 automobile costs $37,500 in pre-tax dollars.

When considering large expenditures, I like to think in terms of how long it will take me to earn enough after-tax dollars to pay for the expense.  This allows me to frame the decision in an apples-to-apples basis with my income and decide if the item is really worth all of the hard work.

The effects are even more staggering when adding any borrowing costs into the equation.  Continuing on with the $30,000 car example, if I go down to my local auto dealer, sign a contract to buy a $30,000 vehicle and also take out a 66 month loan at 8% to finance the transaction, I will pay $7,180.74 in interest to the bank for the loan.  Now, the car costs $37,180.74 in post-tax dollars.  At a 20% total tax rate, the pre-tax costs add up to $46,475.93, a 55% increase over the stated cost of $30,000.  At a 35% total tax rate, you will need to earn $57,201.14 in income to pay for the $30,000 car and pay off the loan over the full term, which equates to a 91% increase over the $30,000 figure.  Now, that shiny new car doesn’t look like such a good deal.