Almost anywhere you turn, you see news stories about the widening gap between the rich and the poor. As a result of this inequality, many prominent figures have come forth with their thoughts on how to fix things. Some want to raise taxes on the rich. Others want to raise wages for those working certain jobs.
Why the Rich Keep Getting Richer
What I don’t hear a lot of talk about though is why the gap really is widening. The reason is twofold: the rich invest their money and the government taxes income, not wealth. Let’s look at these two in more detail.
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The Rich Invest
If you create an investment plan and hold a diversified portfolio for the long-term, you are going to experience an increase in the value of your investments. Just look at any historical chart of the stock market and you see that over the long-term the market trends up. Note when I say long-term, I am talking 20 years or more. Even with recessions and stock market crashes, in time the market always comes back.
The rich know this and they invest in the stock market, both for price appreciation and for income. I’ll get to the income part shortly. But the price appreciation is where most other investors fail. The market takes an unexpected drop and people sell out. I bet with the recent volatility a bunch of people ran for the hills. This is exactly the wrong thing to do. When an airplane hits turbulence, does the pilot land the plane and cancel the flight? No, he pushes through knowing that it’s just a little bump along the way. If most investors could take this same view, they would experience the price appreciation of the stock market over the long-term as well.
Read More: 3 Steps to Successful Investing
Taxing Income, Not Wealth
As it stands now, our tax code is set up to tax income. If you make $500,000 from a job this year, you are going to pay close to 40% of that in federal income taxes. On the other hand, if you earn $500,000 from your investments as long-term capital gains or qualified dividends, you are looking at a maximum tax rate of 20% (plus a portion which could be subject to the Investment Tax). That is a huge difference!
The rich know this and “earn” a good amount of their money from investments and not a job like you and I have. This allows them to keep 20% more of their money.
Read More: Do the Rich Pay More or Less in Taxes?
Generate Investment Income: How To Make The Transition
Obviously, you should want to make the transition from generating most of your income from a job to your investments. How do you go about doing this?
First, you need to start investing in the stock market and then stay invested, no matter what happens. By staying invested, I mean keep the holdings you currently have. You can’t jump from one mutual fund or ETF to another every 6 months or year. You have to hold the same positions for the long-term.
But, you can’t just invest $20 here and there and expect to see any results. If you truly want to reach a point where you are living off of the income from your investments, you need to invest a decent amount of money. In order to do this, you are going to have to make some sacrifices. Question the things you buy. Do you really need the new iPhone 6? Can you shop around for insurance coverage and get a better deal? Does refinancing make any sense for you? The more ways you can cut costs and invest more, the better off you will be.
Read More: Why You Should Save 1% More Each Year
An Example of Making The Transition
Let’s say you really want to make the transition. Start by looking at how much you spend in a year currently. Let’s say you spend $40,000 per year. We will assume that the investments you choose (a healthy mix of stocks and bonds) will throw off around 3% worth of income each year. If we do some fancy reverse engineering ($40,000 divided by 3%) we get $1.3 million. This tells us that you need to invest $1.3 million. That amount will generate an annual income of roughly $40,000. (Note that I did some rounding to make this easier to follow.)
You are probably looking at this and thinking there is no way I can save/invest $1.3 million. While it may not be easy, it is possible. You just have to do some thinking outside of the box. How close are you to paying off your mortgage? If you get rid of that expense, your annual expenses will be much less than $40,000 meaning you need to save less than the $1.3 million. Same goes for getting rid of a car loan or buying an older car so your insurance coverage is lower. Or maybe even moving to an area where the property and school taxes aren’t so high.
I’m not saying you have to do any of these things, I am just showing you it is possible if you expand your thinking. Maybe none of those things are worth it to you. If this is the case, then maybe you revise your goal. Maybe instead of living off of 100% investment income, you replace 50% of your income with investment income. This would allow you to quit your job and work in a field that pays less, but makes you much happier.
I am certain that if you just take some time to think about various ways to cut your expenses or to change the overall plan, you can find something that will work for you and allow you to earn an income through your investments. Don’t give up hope too quickly, there are always other options.
The real reason why the rich are getting richer is because they are investing their money in the stock market and taking advantage of lower tax rates. You too can take advantage of the lower tax rates, you just have to start investing for the long-term. While the challenge of building up your investment income might sound overwhelming, focus on the benefits that it will provide you and how much happier you will be.
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