How To Beat Taxes With Passive Income
So, you want to be a stock investor. The next logical question should be, “How should I invest in the stock market?”
The interesting thing is that most people only know of one way to invest in the stock market, so they never ask the question of how they should do it.
The tricks to successful stock investments are to match your investing goals with the right investment strategies – and no, your investment goal can’t be simply to make money.
I never wanted to be a stock investor. I don’t even consider myself a real estate guy. I invest for one thing: cash flow.
My rich dad spent a lot of time playing Monopoly® with his son, Mike, and me when we were children. We would play for hours exchanging four green houses for one red hotel. Buried in that simple formula is a powerful lesson, a lesson that has served me well throughout my adult life.
That was one of the first, and most important, lessons in financial education I ever learned: the value of cash flow.
Monopoly® is a game that teaches you how to create positive cash flow. You purchase a property and collect rents when someone lands on your property. In order to make money, much like in real life, you improve the value of your properties and eventually sell them. When you move on from single-family homes (green houses) and into larger properties like duplexes, 4-plexes, and, eventually, apartment complexes (red hotels), you increase your cash flow.
Thankfully, I learned about cash flow early at an early age by playing that game. Unfortunately for most people, however, it’s a lesson they never learn.
It’s important to understand that following the lessons from my rich dad, and playing the game of Monopoly, has allowed me to make money differently than someone who follows traditional advice.
It’s by earning money through the non-traditional means that I went on to become a multi-millionaire. And one of the key reasons I became wealthy is because I understand the three different types of income. They are:
- Ordinary income – highest taxed income
- Portfolio income – second highest taxed income
- Passive income – lowest taxed income, possibly zero
My poor dad worked for ordinary income, the highest-taxed income there is.
My rich dad worked primarily for passive income, the lowest-taxed income.
These terms for the three types of income actually come from the Internal Revenue Service. The tax department taxes the three incomes at different rates. An entrepreneur has the opportunity to work for all three types of income and needs to know the differences because the different tax rates can make a huge difference to the bottom line.
I mention these incomes now not to confuse you, but to distinguish them from the discussion on the three different types of money I am about to discuss when it comes to stock investing.
Three Types of Income
Ordinary Earned Income
If you have a job and receive a paycheck, you make your money through earned income.
When you earn money through a paycheck, you are exchanging time for money.
For example, if you wanted to make earned income in stocks, you’d probably be working at a brokerage or start a hedge fund where you are getting paid a predetermined amount of money (X) to do that job for a certain amount of time (Y).
Portfolio income is, in most cases, known as capital gains in the investment world. Generally, capital gains are achieved when you buy low and sell high. In the stock market, a person can sell high and buy low, aka shorting a stock, and achieve capital gains, a profit.
Most people who invest are interested in capital gains. Investing for capital gains is not really investing. It is technically trading, which is why it receives a different tax status. Trading is buying something in order to sell it. Traders do not really want what they have purchased. Traders are no different than a dress-shop owner who buys dresses at wholesale and sells the same dresses at retail. This is why most traders are in the S quadrant, and many are taxed accordingly.
If stock investors want to increase their net worth with stocks, they can buy shares and hold them in their portfolio, hoping they increase in value. Many people are already doing this through retirement plans such as a 401(k), an IRA, and mutual funds.
For Kim and me, our objective is always cash flow, aka passive income, which is why we named our board game CASHFLOW. To us, cash flow for life is our financial freedom. The passive income allowed us to retire early and get on with our lives. Ironically, passive income is also the least taxed of all three incomes.
If your goal is to generate cash flow, you may want to use the strategy of selling options to meet your cash flow goal. Cash flow is valuable to you because it’s how you are able to feed your family and pay your bills.
Simply having an asset that increases your net worth does nothing to improve your cash flow situation. There are many people who are rich on paper but poor in cash. Lots of people found that out the hard way when the dot com bubble popped in the early 2000s. Thousands of “millionaires”, people who had stock options in high-flying tech companies, became “poor” overnight. That’s why Rich Dad encourages people around the world to think differently and seek assets that give them cash flow.
When you have assets that generate cash flow for you, it can help you now and through retirement. Remember: Net worth doesn’t help you retire; cash flow does. Your net worth doesn’t pay the bills; the cash that comes into your bank account each month does.
That’s an important distinction to make. If you are selling options on your stocks, that is cash flow that goes into your income statement. It’s an important addition to your income statement that can transform your life.
How Taxes Affect the Three Types of Income
Ordinary earned income is how most people make a living. It’s also why most people are considered poor or middle-class. But the reason most people are designated poor or middle-class doesn’t have anything to do with how much money they make, but rather how much they keep.
The biggest expense for an employee or small business owner isn’t their mortgage, car payment, or credit card bill. For people who make a living with ordinary earned income, their greatest expense is their taxes.
People who earn income through a job (either as an employee or as a sole-proprietor/small business owner) lose roughly 50% of their money through taxes. As I stated above, earned income is the most highly taxed of all three types of income.
Making money through portfolio income won’t save you much with your taxes, either. No matter how much you make selling stock, or even real estate, you’ll be taxed at approximately 20%.
Before you take a position in the market, remember that not all income is created equal
When most people set their investing goals, they think very little about the fact that different positions would bring about different results. As we learned, all income is not created equal.
Editor, Rich Dad Poor Dad Daily