Believe It Or Not, Income Isn’t Created Equal
Rich dad said, “Investors control. Everyone else gambles. The rich are rich because they have more control over their money than the poor and middle-class. The moment you understand that the game of money is a game of control, you can focus on what is important in life, which is not making more money but gaining more financial control.”
“There are three different kinds of income.” Rich dad stressed that I should know the difference between these three different types of income.
“It’s important because the characteristics of the income are what separates the rich from the middle-class,” rich dad said. “The poor and middle-class focus on ordinary earned income, also called wages or paycheck income. The rich focus on passive income and portfolio income. That is the fundamental difference between the rich and the middle class.”
“In America and other advanced economies, even the first dollar of earned income is taxed at higher rates than passive and portfolio income. The higher rates are necessary to provide various forms of ‘social insurance,’” rich dad explained. “Social insurance” stands for payments the government makes to various people. (In the United States, this would include Social Security, Medicare, and unemployment insurance, just to name a few.) Income taxes are then calculated on top of social-insurance taxes. Passive and portfolio income are not subject to social-insurance taxes.
“So every day that I get up and focus on working hard to earn money, I am focusing on ordinary earned income, which means I pay more in taxes,” I said. “That is why you have been encouraging me to change my focus on what kind of income I want to earn.”
I realized rich dad was back to Lesson #1 of Rich Dad Poor Dad. “The rich don’t work for money. They have their money work hard for them.” It suddenly all made sense. I needed to learn how to convert ordinary earned income into passive and portfolio income so my money could start working for me.
The Three Types of Income
There are three basic types of taxable income in the United States: earned, portfolio, and passive. Earned income is derived from labor and is taxed the highest of all incomes. Portfolio income is general income from capital gains earned by buying an asset low and selling it high. It is the second-highest taxed income. Passive income is generally income from cash flow and is the lowest taxed of the three incomes.
- Ordinary income
Ordinary income is generally paycheck money. It is the most highly-taxed of all three incomes. Most people go to school to learn how to work for ordinary income. After graduation, most go on to become wage earners. If you work for money, you are working for ordinary income. Ironically, interest on savings is also taxed at ordinary-income rates. And when you retire, your 401(k) income will be taxed as ordinary income. In my opinion, there are better ways to save for retirement than a 401(k) plan.
- Portfolio income
Portfolio income is also known as capital gains. Most investors invest for portfolio, income, or capital gains. A capital gain occurs when you buy low and sell high. For example, if you buy a stock for $10 and sell it for $15, this is a capital-gains event with a proﬁt of $5 and that proﬁt is taxed as portfolio income.
Taxes are one of the many reasons why I rarely invest in stocks. It makes no sense to me to take risks by investing in stocks only to pay taxes if I win. Capital gains on real estate and stocks are currently taxed at 20 percent. Dividends from stocks are also taxed at 20 percent.
- Passive income
Passive income is cash flowing from an asset. Your asset is producing money. In real estate, passive income is called rental income. For example, if I buy a rental property for $100,000 and my net monthly rental income is $1,000 a month, the $1,000 is passive income. Passive income from real estate is the lowest-taxed income, sometimes at 0%.
Investing in tax-free cash ﬂow requires the highest level of ﬁnancial education and experience.
Now that you have a basic understanding of the three types of income, now it’s time to gain a great understanding of how each affects your greatest expense: taxes.
How Taxes Affect the Three Types of Income
Where a person resides in the CASHFLOW® quadrant—meaning where their income comes from—determines how that income is taxed. The diagram here depicts diﬀerent types of income from diﬀerent quadrants… and who pays the highest percentages in taxes today.
As you can see, advising and encouraging your child to “go to school and get a job” in the E quadrant or “go to school and become a doctor or lawyer” in the S quadrant is advising them to work for income on which they’ll pay the highest percentages in taxes. The doctors and lawyers in the S quadrant, pay the highest tax percentage of all quadrants.
Whenever the masses cry out, “Tax the rich,” the taxes are raised on high-income wage-earners in the E and S quadrants, people like CEOs, doctors, and lawyers. The truly rich, the true capitalists in the B and I quadrants, pay very little, if any, in taxes.
Want To Pay Less In Taxes? Create Passive Income
The point is this: not all income is created equal. Passive income, the kind of income generated on the right side of the quadrant is much better than earned income, the kind earned on the left side of the quadrant. Passive income is taxed less, and it’s also a result of cash-flowing assets, not selling your time as an employee.
But here’s the catch, not just anyone can start making passive income on the right side of the CASHFLOW Quadrant. It takes financial intelligence to start a successful business and to make great investments. The good news is that anyone can increase his or her financial intelligence through financial education.
If you want to make more money, keep more money, have more time, and pay less in taxes, the first step is knowing how money works and how to make it work for you.
Editor, Rich Dad Poor Dad Daily