The More Money You Earn, The Less you Keep
During the 2020 U.S. Presidential campaign, now President Biden promised to “tax the rich.” In fact, it seemed like it was a repeat of President Obama’s campaign mantra. But are they really taxing the rich?
Biden’s “American Families Plan” would raise $1.5 trillion over a decade by taxing the highest earners. Millions of Americans think this is fair. They believe we should tax the rich.
My point of view is different. Notice that Biden’s plan is to “tax the highest earners.” Biden is not taxing the rich, he is taxing high-income earners. It’s the middle class that pays the lion’s share of taxes collected.
The reality is that the IRS tax code is written to encourage and reward certain types of behaviors.
At a high level, the IRS wants people doing activities that spur growth and that provide jobs. Thus, they have many tax breaks for entrepreneurs and investors. On the other hand, the IRS has little value for people who make a lot of money but don’t create anything for the economy in terms of growth or jobs.
So, it then is not surprising that the top 1% of earners pay the largest share of taxes rather than the top 0.01%.
Why? Because most of those in the top 1% are not entrepreneurs or investors. They are high-paid employees who earn the highest-taxed type of income: earned income.
The ultra-rich, on the other hand, are those whose wealth is often built on starting a company or investing professionally.
These activities are rewarded by the IRS and so they have many more tax breaks than even those making hundreds of thousands of dollars a year.
The ultra-rich know how to limit their earned income and instead make most of their money via passive income vehicles like their companies and investments. Thus, they pay a substantially lower tax percentage than high-income earners.
Taxes By Quadrant
To illustrate and explain the subject of taxes, rich dad drew the CASHFLOW® quadrant for me.
The letters in the four quadrants represent:
E – for employee
S – for small business or self-employed
B – for big business (500 employees or more)
I – for investor
Each of us resides in at least one of the four sections or quadrants of the CASHFLOW® quadrant. Which quadrant we are is determined by where our cash flows come from, hence the name CASHFLOW® quadrant. A person can have multiple streams of cash flow and reside in more than one of the quadrants.
Employees in the E quadrant are people with steady jobs who rely on paychecks.
Those in the S quadrant are self-employed who work by the hour, for a commission, or on a fee basis. Many “doctors and lawyers reside in the S quadrant.
The B quadrant is filled with people such as Steve Jobs and Bill Gates—entrepreneurs who start large businesses.
People in the I Quadrant are professional, active investors like Warren Buffett.
Most people are passive investors who invest in pensions, IRAs, and 401(k)s. Since they are passive investors—not professional investors—their investments are taxed at higher levels.
Most CEOs are in the E quadrant. They are known as “managerial capitalists,” employees who work for entrepreneurs. True capitalists are people like Steve Jobs, Bill Gates, or Mark Zuckerberg, entrepreneurs whose companies employ more than 500 employees and who transitioned from the S quadrant to the B and I quadrants.
Our school systems prepare people for the left side of the CASHFLOW quadrant, the E and S quadrants. That is why most parents advise their kids to “Go to school to get a job” (E quadrant) or “Become a doctor or lawyer” (S quadrant).
The differences in taxes between the people and the quadrants are extreme.
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.
Understand Where Your Income Comes From
Most parents teach their children to work for ordinary income. That’s what most people work for. They do so when they advise, “Go to school, get a job, work hard, save money, invest in a 401(k).” All generate ordinary income, the highest taxed of all incomes.
- Poor people’s income: Ordinary Income
Ordinary income is poor people’s income because the more you earn the less you keep. That is not financially intelligent. Many people go back to school, work harder or work overtime, hoping to earn more ordinary income. Earning more money pushes them into higher and higher tax brackets. Again, the more they earn the less they keep.
- Middle-class income: Portfolio Income
Middle-class investors are counting on their stock market portfolio to keep them alive once their working days are over. The same is often true for many government employees. Many government-employee retirement funds have been counting on gains in the stock market (8 percent per year is the percent of increase we often hear talked about) to meet their obligations. If the returns aren’t there, will the retirees get less money or will the government employee bureaucracy seek to raise taxes on the rest of us?
- Rich Income: Passive Income
Passive income is also known as cash flow. The truly rich are rich because they have this type of income. Passive income is earned on the right side of the CASHFLOW Quadrant, and therefore, taxed at the lowest rate.
You Can Pay Taxes Like the Ultra-Rich
The biggest difference between the “rich”, that is high-income earners, and the ultra-rich is a mindset. And the good news is that you can start thinking like the ultra-rich when it comes to taxes and money, and watch your wealth grow.
First, stop looking for a high-paying job and start thinking about how you can create them instead. The IRS will reward you if you take entrepreneurial risks.
Second, invest your earned income into assets that produce passive income via cash flow every month. The IRS will also reward you for that. By this, I do not mean your 401(k), which is taxed at an earned income level. You have to find true assets like rental properties, businesses, and commodities that are taxed at the passive income level.
You do not have to start big. Just do what you can and continue to build into larger and larger opportunities. The most important thing is to think like the ultra-rich, not like an employee.
Editor, Rich Dad Poor Dad Daily