By Scott Cook
Over the long term, building wealth is one of the best forms of planning for retirement, ensuring your financial security, having something to pass on and just giving yourself the ability to enjoy life a little more. There’s nothing wrong with creating a little wealth, so don’t let anyone tell you otherwise!
Of course, wealth can mean any number of things. It can mean a little extra to spend, total financial freedom or even being among the super-rich. Essentially, wealth is defined like this:
Wealth = the number of days you can go without working and still pay your expenses.
For example, if you have $3,000 in the bank and your monthly expenses are $4,000, then you have about 23 days of wealth.
If you’ve created a stream of income that brings in $4,000 or more each month… then you are infinitely wealthy. In other words, you’re financially free. Not rich, but not tied to anything like a job, for example.
So where is wealth created?
In order to answer that, let’s look quickly at the three income types and how they’re taxed and how this relates to your wealth building plan.
This is the most common. Earned income is what you get from your job, interest earned from bank accounts, tips , and even how your 401K withdrawals are classified once you begin doing so.
This income category is the highest taxed and offers the fewest opportunities for creating wealth. In fact, it’s safe to say that if you want to be financially independent, then you need to move out of this category as soon as possible.
For example, earned income tax ranges from 10% to 35% and is also subject to social security and Medicare tax which is about 14%. The deductions you can take are very limited.
This form of income is derived from capital gains on investments, stock dividends and so on. Unlike earned income, there is no social tax, so immediately, you’re tax rate is already improved.
For instance, for investments held longer than 12 months, any capital gains is taxed at between 10% and 20% and can be offset by a loss from another investment. So let’s say that you sold some stock for $8,000 that you bought for $2,000. Additionally, another stock actually lost $2,000 in value. Your actual capital gain then is only $4,000.
This category is a good place to create wealth, but not the best place. Once you read about passive income, you’ll see that in fact, portfolio ventures when funded by passive income gives you the best advantage.
This type of income is called passive because it comes from things in which you don’t take a day to day interest. This includes such things as rental real estate and being a limited partner in a business venture. It doesn’t mean you can’t participate, it’s just that you don’t work on it every day like a job.
What’s great about passive income is that many expenses are paid pre-tax. You can also offset other income by up to $25,000 with an overflow of tax deductions from the passive income. Of course, there are rules about how long you can do this based on your income, but it’s a great way to limit your tax liability.
Passive income sources like real estate investments have many advantages, too many to name here, and this is where wealth building should begin. Passive investments can be set up to replace your job income and then can spill their profits over into portfolio income sources such as stocks to create a robust and ever-increasing source of financial freedom.