If you'd asked me a few days ago to tell you what I thought was the definition of "being rich" was, I would have likely told you that it was a large net worth or a big monthly income.
I was wrong.
After having spent the last three days in a room with some very wealthy investors while taking a course on how to better understand money, I have now realized that the definition of wealth is quite different. Consider the following basic formula:
Cash flow from Assets (CFA) > Monthly expenses.
In other words, when income from your investments exceeds your chosen level of living expenses, you are wealthy. Pretty simple, huh?
In my first career as a stockbroker, I made lots of money every year. I also spent lots of money every year. I thought I was wealthy at the time.
In my second career, I founded a technology company that made me a millionaire on paper. Once again, I thought I was wealthy.
The sad truth is that I was not wealthy in either scenario because I had no passive income from my assets. If I stopped going to work, the money would stop coming in. This is not wealth.
My realization this weekend is that wealth comes from two primary sources: rent and interest. If you own real estate, you can rent it out. If you have money, you can rent it out, too. In either case, you don't have to do much in the way of "work".
So, how does one CREATE wealth? Simple. You begin by creating a GAP between your income from your job and your monthly expenses.
Sounds easy, right? I used to think so, and my method of solving this problem was to focus on increasing my income while not putting a whole lot of thought into my expenses. In my mind, I could "afford" all the toys I was buying because I made a lot of money.
Oops.
The mistake that I made was that I didn't PRIORITIZE how I treated my money. Most people have income, then they spend, and then they save. The problem is that when the spending is done, there is nothing left to save. Wealthy people, on the other hand, have income, they save, and then they spend.
The difference between the two approaches is HUGE.
Here's why: every dollar that you save is like a soldier and as an investor, your job is to send that soldier back out to fight (earn a return). Spending your money is akin to killing your own soldiers. You aren't likely to win too many wars with this approach.
Think of the Golden goose. If you eat the goose, no more eggs. If you let it lay eggs and you don't eat them all, you'll end up with more geese and they will lay more eggs, and you can then eat some of those, and then you'll have more geese, etc, etc...
Killing your soldiers is the equivalent of eating the Golden goose, and let me tell you, I was an EXPERT goose killer!
So, which do you think is easier to do; increase your income, or reduce your expenses? You guessed it; reducing your expenses is far easier. Not only is it easier, it also has another very important difference.
For every dollar you save, you get to keep the
entire dollar. Whereas, for ever dollar you earn, you get taxed and you get to keep only a fraction of the dollar.
In other words, taxes can make you wealthy, if you understand the system.
Consider this; if you earn $50K per year in earned income in California, your top marginal tax bracket will be about 40%, and your effective tax bracket (the total amount of tax you paid as a percentage of your income) will be about 20%. If you are self employed, the story is much the same.
If, however, you earned $50K from rental income, you will hardly pay any tax at all. Why? Its this little thing called depreciation. For every piece of real estate that you own, you are able to depreciate its value over 27.5 years. In this example, when you take depreciation into account, your taxes due on a $50K income will amount to about 3%, or $1600, for the entire year. In other words, you are going to have the after tax income of someone who earned well north of $75k.
In my next few posts, I'll cover some of the ways that you can invest the money from the Gap you've created.
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TRD
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