Wealthy People Don’t Realize Their Income
Misleading, I know, but it’s not that they don’t know how much they make, it’s more that when they make the money, they don’t spend it (also known as “realizing their income”).
What is the difference between realized income versus unrealized income?
Realized income is for instance your salary, or any money you have to pay tax on.
You make $40,000 a year, and you get paid the full $40,000 which means you have to pay taxes on it as well, you can think of it as any time you earn money (even on your investments), and want the cold had cash in your pocket at the end of the day.
Unrealized income is money that you “earn” like when your investments go up in value, but you don’t sell them to get the profit or the cash into your bank account, which would turn it into “realized” income.
A home is another perfect example of unrealized income.
You bought the home for $200,000 (let’s say you bought it outright or you’ve paid the mortgage off), and it is now worth $400,000.
Your net worth has now gone up $200,000 but you haven’t realized the income, because you haven’t sold the home for $400,000.
Millionaires maximize their unrealized income
A typical millionaire next door has a realized income that is equivalent to only 8.2% of his wealth.
This means that they only take 8.2% out of their investments, their companies, their salaries or what have you.
Net worth of $50,000
So let’s say you have a net worth of about $50,000:
$50,000 x 8.2% = $4100
This means that if you had $50,000 as your net worth, you’d only spend about $4100 a year on your expenses like rent, and food.
That’s near impossible!!!
Net worth of $1 million
But if you have a net worth of let’s say $1,000,000:
$1,000,000 x 8.2% = $82,000
A person with a million as their net worth, to be in the millionaire mindset, spends about $82,000 a year.
Of course, there are certainly millionaires who spend a lot less than that, but that’s the median.
My personal situation: ~$540,000 in net worth
$540,000 x 8.2% = $44,800
That means I’d have to spend about $44,800 a year to have a millionaire mindset or $3735 to have a millionaire mindset.
I could do that.
It’s surely something I’m thinking about now.
How can I start thinking and managing my money like a millionaire?
The biggest thing that ordinary folk like us can do, is to put the MAXIMUM into tax-deferred and tax-sheltered retirement plans.
TAX-DEFERRED: 401K & RRSP
Tax-deferred plans like the 401K for Americans and RRSP for Canadians are the easiest way to not realize any income until you go to retire (then you’ll get taxed when you withdraw the money, but you’ll need the money anyway!).
This means if you invested $5500 in your RRSP this year, you would not be paying income taxes on it (it’d lower your taxable income), and in 40 years it’s $38,719 at 5% interest, and you will be taxed on that $38,719 when you go to realize that income at retirement.
- No income tax paid on the year you contributed the money (lower taxes)
- Money grows tax-free for the whole period it’s in your tax-deferred plan
- You’re taxed on the money when you go to withdraw it (presumably) at retirement age
- It’s locked-in, and you can only withdraw it for a home or education, but you have to pay it back
TAX-SHELTERED: Roth IRA & TFSA
For things like a Roth IRA for Americans or the TFSA for Canadians are tax-sheltered plans, so don’t write them off either! You should also max them out if you can.
Tax-sheltered means that even though you pay taxes on the income first before putting it into a Roth IRA or a TFSA, you can invest that money which will then grow tax free until you retire.
So imagine if you invested that $5500 in a TFSA this year, and you’d pay income taxes on that $5500 this year. In 40 years it turned into $38,719 at 5% interest over the long-term, if you went to take out that $38,719 from your TFSA, you won’t be taxed on it.
- Money grows tax-free for as long as you leave it in there
- It’s not locked-in, you can take it out any time you want and have the room available later on
- You won’t be taxed on the money if you take it out (at any time you want)
- You’ll be income taxed on that money in the year you contributed it (full income taxes)
Contributing and maxing out the above accounts basically lets you not “realize” the income, because you will not be taxed on anything you contribute, and it lowers your taxable income as a result.
WHAT ABOUT SMALL BUSINESSES?
As a freelancer, the best thing to do is to have a company, make money with that company, and take out as little as possible as your salary.
Leave all the money in your company, invest your retained earnings, let it grow and be taxed under the company, and slowly siphon off money from your company when you go to retire.
The reason why this is awesome, is because you get taxed at company rates (much lower than individual rates), it’s still all your money (assuming you’re the owner and sole shareholder), and you get a built-in nest egg when you go to retire.
In doing so, the main downside is that if you don’t take a salary (you take dividends from the company instead) and contribute to Social Security or CPP, you won’t get much from the government when you go to retire.
You are REALLY on your own for your retirement with this kind of strategy.
WHAT ARE SOME OTHER THINGS I CAN DO TODAY?
- Know and calculate what your net worth is (how much you have minus how much you owe)
- Know how much you spend yearly by budgeting and tracking your expenses
- Calculate how much you spend yearly versus your net worth (see above)
- Pay down your consumer debts so that you aren’t wasting your money on high interest rates
- Save and invest as much as you can but don’t realize that income
- If you decide to buy a home, pay for it in full and keep it for as long as you can
Saving your money outside of your retirement accounts, buying a home and keeping it, and investing it on the stock market, and leaving it there (that is, don’t take out the money as “cash” in your bank account), is another way you can make money without realizing it.
The key is to grow your net worth.