OK you guys, I think I figured it all out. This morning, while I was thinking about what a great idea it was to switch from tea to espresso, it all came to me. How to really think like a rich person.
So I will cut right to the chase: I figured out the duality of our relationship with income. And the duality hinges on taxes, which are the largest cost eroding our income. They say that a PhD program is when you go from being a consumer of information to a producer. So ideally our relationship with money is sort of the reverse: we start out being primarily producers of income, and the goal for many is to shift until your relationship with money is primarily one of consumption – and as little as possible. And I am not just talking about saving money and then retiring and spending it all. I am talking about the shift from active income to passive – YOU should not need to produce any more taxable income at some point in your life because your money passively does it for you, tax-free until you consume.
For most of us who do not start out with lots of money, the natural goal is to build up a bunch of it through stable employment. We actively produce as much income as possible because any income is better than no income and zero net worth. But the more quickly we hasten up the ladder, the more we thirst for promotions, we are actually shackling on more and more taxes which burden our income. Once you have “made it” enough to be happy, at least 25% of your income is taken away via tax! Now I appreciate public services just like anyone. But a 25% marginal tax bracket, let alone 28% or 33% when you’re really making bank, just sounds like a lot of money. In fact I think this is the single largest hindrance to amassing wealth, dollar for dollar.
So climbing the ladder for survival in order to build a nest egg makes sense – but only for so long, if you are interested in conducting a frugal consumptive lifestyle. At some point it makes sense to dodge all of the tax burden of making big bucks if you are not even planning on spending them wildly. Regardless of your feelings about a professional career, it makes most financial sense to funnel your money into income-generating investments and live off those accounts only as necessary. The lower-taxed capital gains, consumed at a frugal rate, ensure a much lower rate of tax on this realized income.
So if you are working hard at the office all your life AND living frugally for whatever reason, you are really paying for the privilege of an office job via steep taxes on the active income produced by your blood, sweat, and tears. The only reason to work for a corporation for your whole life (aside from loving your career and making the conscious choice to pay staggering Income Tax for the ability to do so) is if you are a spendaholic and are not able to amass savings that can make a passive income lifestyle available to you.
What I was originally thinking about this morning is why everyone makes such a big deal about tax, and realized that the transition from active income production with Income Tax to passive income production and low income consumption with Capital Gains Tax is like going from the real world into the Matrix. There is no comparison.
Right now you may be working for The Man and you are struggling, begging even, to get into the 25%, 28%, and even 33% tax brackets via greater income. But if you then take most of that money and put it in investments and continue to live frugally, even the capital gains from short term investments would be taxed at your rate of consumption (your cost of living by taking distributions on your investments), which would be, say, 15% if you are really frugal like MMM. Even if you want to live more luxuriously in the 25% tax bracket of $36,251 – $87,850 consumed (not produced), you still didn’t have to go work for 40 hours a week! Or, you worked for yourself, on your terms, and maybe even provided a job for one or more other people. And there are further capital gains tax deferral and reduction strategies from there.
So I guess the questions I’m left with are: is your job or career worth a quarter or more of your income, forever, and the opportunity cost of forfeiting your ability to go work for yourself? And if you had a large pool of passively produced income, would you be able to take frugally from it, or would you go crazy? Would you be scared, consuming passive income?
Image credit: http://www.memecenter.com/fun/2162829/astrocat