We've all seen the headlines about how the wealthy pay less in taxes than the "average" American. Have you ever wondered why investors and business owners like Warren Buffett, Jeff Bezos, and Mitt Romney have lower tax rates than their employees? During a 2012 interview, Warren Buffett famously said, "I pay a lower tax rate on much of my income than my house secretary, and I think that's crazy."
To be clear, Warren Buffett isn't saying he pays fewer taxes, dollar for dollar, than his employees. Instead, he's saying that the American economic system so favors investors and business owners, that the effective rate, or actual rate, at which his income is taxed verse an "average employee" is so much lower, that it constitutes an unfair advantage for the wealthy.
As to whether the American economic system is genuinely unfair, I leave that to the realm of politics. My focus is to explain why Buffett made this statement and how you can use his insight to increase the chances of reaching your financial goals.
How The System Favors The Wealthy
When I was in my early twenties, I picked up a copy of "Rich Dad's CASHFLOW Quadrant: Rich Dad's Guide to Financial Freedom" by Robert Kiyosaki. Kiyosaki is most famous for writing the book, "Rich Dad, Poor Dad." There is much about Kiyosaki's work that I question, including his avocation of the heavy use of leverage in real estate investing. But just because I disagree with some of Kiyosaki's ideas doesn't mean I disagree with all of them. The concepts outlined in "The Cashflow Quadrant" fundamentally changed my view of the various career paths and clearly explained, on a high level, how our system works. After reading his book, it was like a light bulb went off in my head, and from then on, I've never viewed the pathways to financial success the same way again.
For an in depth explanation of the cashflow quadrant click on the below video produced by Jeff Rose:
E = Employee
As an employee, you exchange your time and effort for an income. Income is limited by the number of hours you work in a day. If you don't work, you don't get paid. Employees work for corporations, small businesses, or the government. Employee's trade security for a set level of income. Most Americans fall into the category of employees. Employees in the American tax system receive the least number of tax deductions and pay the highest effective tax rates.
S = Self-Employed
Self-employed individuals are small business owners and are usually specialists in a trade or field. Self-employed individuals trade time for money. Being self-employed requires direct participation in the business and is limited by the number of hours the specialist can work. One advantage of being self-employed is that they tend to have more personal freedom than salaried employees. Self-employed individuals are better off from a tax perspective as they can take advantage of many more deductions compared to regular employees. However, they still have relatively high effective tax rates.
B = Business Owner
Business owners create, own, and invest in business systems. Business owners hire employees to execute the business, which generates profits for owners. Income is not limited by the number of hours in a day and is scalable. Business ownership is not a completely passive activity. Still, many business owners can create multiple business systems that, in theory, can function without the direct participation of owners in the day-to-day operations. In our tax system, business owners can take advantage of a myriad of legal tax deductions and methods, which results in lower effective tax rates than self-employed individuals and employees.
I - Stands for Investor
Investors don't trade time for money. Money works for them. They buy stocks, stakes in businesses, or other forms of investments that may appreciate over time and also make payments to them without direct participation. Investment income is passive by nature. The tax system favors investors by taxing investment income and dividends at much lower rates than employee wages. Also, many investors can write-off losses when assets go down in value. Investors have the highest level of personal freedom and are not dependent on the number of hours worked or the successful execution of business systems. Investors pay the lowest effective tax rates in America.
Traveling The Road To Financial Freedom
You don't have to be Warren Buffett, Jeff Bezos, or Bill Gates to reach your financial goals. If your disciplined and determined, you can generate significant amounts of wealth in any of the four cashflow quadrants. However, income derived from the B and I quadrants is more efficient and far more scalable than income generated in the E and S quadrants.
The key to greater financial success is to think of ways you can move from the top left quadrant to the bottom right. The more quadrants you're active in, the more your income increases, the more diversity in investments, and the more opportunities you'll have to use the tax code to your favor.
For example, as an employee, you can immediately move a portion of your cashflow from the E quadrant to the I quadrant by funding your 401(k). You can increase your skills to get a pay raise or a better job, then use the excess funds to pay down debt and begin investing in low-cost index funds. When moving from the E to S quadrant, you can pick up a side hustle using newly developed and marketable skills. If you have a passion for investing in real estate, you can work to purchase a multifamily property, vacation rental, or use your property as a short-term rental. If you have a desire to be a business owner, find a product you can sell and work to deliver it to the market.
If you're already doing well as an employee, self-employed, or business owner, your goal is to build and maintain your wealth by continuing to work and invest in a smart, risk-adjusted way. You'll need to focus on managing risk, keeping 'lifestyle creep' a bay, continually evaluating financial tradeoffs, and utilizing the tax code to reduce your tax bill. Once you have more income then your expense from your E, S, B, and I quadrant activity, you're financially independent.
The Role of the Financial Planner
CERTIFIED FINANCIAL PLANNER™ professionals are in a unique position to assist clients to increase activity in each of the four cashflow quadrants. It doesn't matter which quadrant you derive your primary income from. Whether you're an employee, self-employed, a business owner, or an investor, a financial planner, as an expert in personal finance, can apply their skills and knowledge to help you see new opportunities and manage your current activity within the various quadrants.
For many people, getting started is half the challenge. A financial planner can help you make this leap. For some, this may be as simple as regularly contributing to a 401(k) and learning to save more effectively. For others, it will be providing sophisticated financial advice. The point is, by engaging in the financial planning process, you have the opportunity to shift your income generation capability within the cashflow quadrants so you, too, can benefit from the very elements of our tax and economic system that favor the wealthy.
After reading about the cashflow quadrant, if you have questions on how you can increase activity in any of the four quadrants or if you wish to learn more about the services Thirty Mile Financial offers, feel free to contact me.