01Income Is Not Wealth
Most people believe the key to wealth is a high-paying job. Yes, it's easier to amass assets if you have more money coming in each month, but one key to increasing your net worth is to spend less than you make. Ultimately, spending habits are the reason a professional athlete making $20 million a year can quickly go bankrupt while a bus driver can retire a multi-millionaire. It can be a cliche but it is a fundamental reality of money.
To escape the spending trap, you need to understand that income is not long-term wealth. What is wealth? Income is obviously a component of wealth, but wealth can have varying definitions. Many people see wealth as their total net worth at any given time. This can be paralleled to the assessment of an individual’s balance sheet. Wealth can be referred to as the part of your balance sheet that is considered equity. Your assets minus liabilities. The wealth you have after liquidating.
Thinking long-term is an important characteristic of accumulating wealth and achieving financial independence. There can be several considerations for long-term wealth, and they will differ for everyone.
If you are a doctor or lawyer, you need to put in long hours after years of specialty training and higher education to get a paycheck. However, in any occupation, as discussed, your annual salary does not necessarily translate to wealth. With long-term thinking, helping to ensure your job’s security, taking initiative to achieve a promotion, or taking steps that will result in higher sales commissions can all be factors for wealth and ways to help ease your anxieties over financial independence.
Side gigs, private investments and a host of other variables can also be utilized for long-term thinking, wealth accumulation, and achieving financial independence. A few considerations here may include a portfolio of private businesses, car washes, parking garages, stocks, bonds, mutual funds, real estate, patents, trademarks. Some of these cash generators can be relied on for long-term income in addition to your job or just as cash generators that can pull in money while you take long vacations or sit by the pool.
Assessing Your Balance Sheet
When you take a look at your personal balance sheet, you may already have organic investments you can rely on in your quest for financial independence. Oftentimes, this is wealth that generates capital gains, income, and dividends without labor. The more of these investments you can afford, the sooner you can fully achieve financial independence.
Reaching a Goal
Overall, the real value of your income is partially determined by the amount you can invest to achieve a financial independence goal. Setting this goal can be important for keeping your perspective on income in check. At your goal, you can successfully maintain the lifestyle you want without working.
Thus, your level of wealth can also be measured by your long-term thinking and potential sustainability. Working with a financial adviser can help you to set a goal for wealth accumulation that allows you to maintain your standard of living without an additional paycheck and achieve the financial independence of your dreams. This goal can be lofty, however, as most people’s annual spending includes a long list of budget items, such as mortgage payments, car payments, clothing, college tuitions, music lessons, entertainment expenses, and more.
02You Must Have Surplus Funds to Invest
As discussed, the only way to take advantage of investment opportunities is to have the money to invest. The reality of successful investing is that there is a certain point where you reach critical mass, and the returns generated on your assets can change your life (e.g., earning a 10 percent return on $10,000 is only going to net you $1,000 before taxes—hardly earth-shattering, but the same return on a $1,000,000 portfolio is $100,000, which has far more utility despite requiring the same effort and research).
Amassing wealth and becoming financially independent is a slow process that takes time. You do small things every day such as cut your expenses, generate extra income and put the money into brokerage and tax-deferred retirement accounts. With time, it begins to amount to something.
As each new opportunity appears, you can react on a larger scale than your previous investments. That's called compounding. It's when the interest, dividends, and capital gains your money has earned begin to generate their own interest, dividends, and capital gains, and on and on in a virtuous cycle. It's how $10,000 can grow to $2,890,000 over 50 years at 12 percent.
Commentator Larry Kudlow pointed out one of the great truths years ago when he said that profits are nothing more than margins times revenue. The profoundness of that statement is sometimes lost by its simplicity. The only way you can have more money left over at the end of the month is to either increase revenue (your paycheck, business sales, billable hours, or whatever it is that provides funds to cover your bills) or decrease costs. That's it. Write it down. Frame it. It's that remarkable. Your choices are to increase revenue, cut costs, or both.
03Taxes Matter — A Lot
Not all income is equal. The idea that where and how you hold your assets can mean the difference between being somewhat well off and obscenely rich is extremely important and was covered in depth in the article entitled Tax Strategy: Asset Placement - Lowering Your Tax Liability Through Intelligent Allocation.
The basic premise is that those with little or no wealth generate a lot of taxable income, while those who end up financially independent generate large unrealized gains in the form of real estate appreciation, unrealized capital gains and profits made through tax-advantaged or tax-free accounts, such as a Roth IRA or 401(k).
An illustration is in order. A physician earning $250,000 per year is going to get taxed heavily, probably paying $95,000 in taxes for a net income of $155,000. Yet, if he had earned the same amount from within a pension plan or IRA, he wouldn't pay a single penny in taxes.
That's an extra $95,000 per year compounding for him. At 12 percent, over 30 years, that's an extra $23 million in wealth. That's right—$23,000,000 simply because the money is earned within a tax-advantaged account instead of regular labor.
This is why you should do everything you can, within reason, to fully fund your retirement plans, as well as to focus on how your seemingly small decisions help or hurt tax planning. No decision is too small.
04Control Over Your Time
Many people factor in control over their time when considering their wealth. Having complete control over your time is often one factor of achieving financial independence. You may not have totally reached the investing goal that allows you to maintain your lifestyle without an additional paycheck, but having total control over how you spend your day can be a variable factored in to how you define wealth.
If each morning, when you show up to the office, or the job site, or the practice field, or studio, it feels like you are unwrapping a Christmas gift—then you are successfully on track for achieving financial independence.
If you find the profession that gives you that feeling, and you are disciplined in your management of the business side of it by controlling costs, you have a huge advantage over your competition because you may continue to work 10, 15, 18 hours a day or 2, 4, or 10 years longer, not because you need to, but because you love the process and product itself.
05Grades Have No Correlation With Wealth and Financial Independence
According to decades of extensive research by Thomas J. Stanley, Ph.D., author of “The Millionaire Next Door,” the grades one earns in school have no correlation with the economic wealth and success other than in the medical and legal professions. That's not to say education isn't important—it is! More than 90 percent of American millionaires did, in fact, graduate with an undergraduate degree.
Why then, do parents, teachers, and counselors continue to tell children that they won't be successful if they have a C- grade point average? Statistically speaking, according to Stanley, it's because often these people are themselves not financially successful.
Therefore, they have no idea what it takes to achieve financial independence and buy into the great myth that good students go further in life. They pitifully measure analytical intelligence only and not the creative intelligence that is responsible for sparking innovations, societal advancements and the opportunity to craft solutions in niche markets that everyone else misses.
They also fail to realize that most millionaires wear blue jeans, overalls, or work shirts, not a suit and tie. They eat McDonald's and Burger King. They live in ordinary, well-established neighborhoods. Most own their own business.
Statistically, if you want to guess who is going to be wealthy and financially independent, you'd be more likely finding a self-sufficient student in wood shop class who paid for his own car, gets decent (but not spectacular) grades, has a job and enjoys what he does than selecting someone from the honor roll. It's counterintuitive, but it's often true.
06Financial Independence Takes a Complementary Spouse
No matter how successful you are, unless your spouse is equally disciplined, frugal, and investment-oriented, your efforts toward a better, financially independent life are going to be like struggling in quicksand.
Marry the wrong person and the emotional, financial, and social toll it can take on your life will overwhelm almost any progress you can make in your career or pocketbook. As you try to build a life, he or she will be out spending your money, making it nearly impossible for you to achieve financial independence.
To truly build a life, you need to have the kind of support that allows you to take risks because you know, no matter what happens, there will always be someone waiting for you at home who loves you unconditionally.
It may sound surprising, but a tremendous amount of success is based on proper temperament and psychology. How can you focus on your work and creating the life you always dreamed of if you are worried about the situation at home? For more information, after you've finished this guide for financial independence, read Love and Money.
07Niche Markets Aren't Glamorous — But They Are Lucrative
Billionaire investor Charlie Munger has remarked that entrepreneurs can thrive if they specialize in an overlooked economic niche, much like animals in nature. Often, these niches are extremely lucrative but not likely to win you friends at cocktail parties.
Conjure up images of a multi-millionaire. What do you see? High-tech 20-somethings on a yacht? Molecular biologists? Although there are a few, most of the big money is in industries such as waste management (garbage), pizza, clothing stores, trailer parks, candles, and shipping.
Consider the case of Sam Walton. He built a tiny dime store from the corner of Arkansas into the biggest retailer in the world, amassing a family fortune of more than $125 billion.
There's nothing sexy about selling 50-cent flip-flops and bottles of cheap cologne in small towns, but Walton was on a mission to bring affordable goods to everyday Americans. He was a man possessed with vision. He built his company one store at a time—one might even say one checkout at a time—with no fanfare or red carpet walks.
Business owners represent a disproportionately large segment of the millionaire population. It's hard to believe, but there's a good chance that the biggest hardware store owner or plumber in your town has a net worth many times that of the highest-paid doctor. Part of the reason is a concept we've discussed called capitalized earnings. Another reason is one Dr. Stanley mentioned in his book. Doctors are pressured to buy status symbols to convince their patients they are successful. Not the plumber. He can put more money into his retirement accounts. Over decades, the result is millions in additional wealth for the guy who unclogged toilets instead of arteries. That's not something you learn about in school.
08Support Your Productive Relatives--Be Careful of Relatives Who Aren't
It is almost always a mistake to provide gifts of cash and support to those relatives who are unable to generate high incomes on their own or who are constantly in financial trouble.
Think of the incentive system you set up! One son becomes a physician and one daughter an attorney and you say they don't "need" your money, while at the same time you provide free rent, board, and bailouts for their sibling, who sits at home in credit card debt but refuses to look for work.
You have managed to effectively turn that child into a financial and credit junkie; it’s unlikely they'll ever get over their addiction. The child may tell you that they only need one more loan, but the fundamental, underlying problem is the inability to manage money.
How to Become Financially Independent
There are several myths and misnomers when it comes to financial planning, and individuals can take in a lot advice from many good and not-so-good sources. Misnomers can range from confusing high incomes with wealth to not knowing the importance of tax asset placement when choosing your investments. This article attempts to shed some light on these areas and to help provide individuals with some key insights that will hopefully lead to a more financially independent life.
This guide to financial independence is part of the How to Get Rich trilogy for new investors.