THE ULTIMATE CONSUMPTION CATEGORY
The typical millionaire in our surveys has a total annual realized income of less than 7 percent of his wealth. This means that less than 7 percent of his wealth is subject to some form of income tax.* In our latest study of millionaires, the percentage was found to be 6.7 percent. Millionaires know that the more they spend, the more income they must realize. The more they realize, the more they must allocate for income taxes. So millionaires and those who will likely become affluent in the future adhere to an important rule:
To build wealth, minimize your realized (taxable) income and maximize your unrealized income (wealth/capital appreciation without a cash flow).
Income tax is the single largest annual expenditure for most households. It is tax on income, not on wealth and not on the appreciation of wealth if this appreciation is not realized; that is, if it does not generate a cash flow.
What is the message? Even many high-income-producing households are asset poor. One reason is that they maximize their realized incomes, often to support high-consumption lifestyles. Such people might wish to ask themselves a simple question: Could I live on the equivalent of 6.7 percent of my wealth? It takes much discipline to become affluent. We have interviewed many people worth $2 or $3 million who have total realized annual household incomes of less than $80,000.
How much does the typical American household realize in income each year? About $35,000 to $40,000, or nearly the equivalent of 90 percent of its net worth. The result is that the typical household in America pays the equivalent of more than 10 percent of its wealth in income taxes each year. How about the millionaires whom we surveyed? On average, their annual income tax bill is an amount equal to only a bit over 2 percent of their wealth. That is one of the reasons they remain financially independent.
CASE STUDY : SHARON AND BARBARA
Sharon is a high-income-producing health-care specialist. She recently asked us, “How is it that I make so much in terms of income but accumulate so little in terms of wealth?”
Last year Sharon’s household had a realized total annual income of approximately $220,000 (see ‘Table 2-3), which places her household in the top 1 percent of all households in America. Sharon’s household has a net worth of approximately $370,000. While Sharon’s income is higher than 99 percent of the other households in America, her net worth is far below what it should be. Given her age, fifty-one, and her income, $220,000, Sharon should, according to the wealth equation (expected net worth = one-tenth age x income), be worth approximately $1,122,000.
Why is Sharon’s level of accumulated wealth far below the norm? Because her realized, or taxable, income is too high. Last year she paid $69,440 in federal tax on her $220,000 income. This is the equivalent of 18.8 percent of her total wealth. Yogi Berra might say, “Sharon, you can’t be wealthy. Your income is too high.”
TABLE 2-3 CONTRASTS AMONG AMERICAN TAXPAYERS
(68 of 277)
We believe that the average person in Sharon’s income/age category pays the equivalent of only 6.2 percent of his wealth in annual federal tax, or $69,440 divided by $1,122,000. Thus, Sharon’s tax equivalent, 18.8 percent of her wealth, is three times higher than the tax equivalent for the average person in her income/age category.
To view this another way, Sharon has an annual realized income that is equivalent to 59.5 percent of her total net worth of $370,000. How could anyone hope to become truly wealthy when the equivalent of nearly 60 percent th is subject to income tax each year? The average person in Sharon’s income/age category realizes the equivalent of only 19.6 percent of his net worth in annual income. Thus, only about $1 in $5 of his net worth is subject to income tax.
What about people who have above-average levels of wealth? How much of their equivalent net worth is being taxed? Barbara is a typical member of the PAW category. Her realized annual income is approximately the same as Sharon’s—$220,000. But Barbara’s net worth is approximately $3,550,000. Therefore, the equivalent of only 6.2 percent of her wealth is subject to federal income tax. What percentage of Barbara’s wealth is paid in federal income tax? Approximately 2 percent. In sharp contrast, Sharon paid the equivalent of 18.8 percent of her wealth in federal income tax, or more than nine times the percentage for Barbara.
The average American millionaire realizes significantly less than 10 percent of his net worth in annual income. In spite of having considerable wealth and substantial annual increases in wealth (in unrealized form), the typical American millionaire may personally be cash poor. More than 20 percent of Barbara’s annual realized income is invested in financial assets that tend to appreciate in value without generating realized income. Sharon, on the other hand, invests less than 3 percent of her realized income. Most of her financial assets are in liquid form.
Sharon’s economic situation is quite risky. She is the main breadwinner in her household, which has little investment income. If her employer eliminates her job, what then? There are not too many positions available today that pay $200,000 or more a year. Barbara, again in contrast to Sharon, has a business with more than sixteen hundred customers—that’s sixteen hundred sources of income. This is much less risky than Sharon’s position. Sharon could not survive for six monthsif she lost her source of income. But Barbara could easily survive for twenty or more years. Actually, she could retire at this point on the income from her financial assets alone.
Barbara, the prodigious accumulator of wealth, PAW , is just one of more than 3.5 million millionaires in America today. More than 90 percent have a net worth between $1 million and $10 million. How do these affluent people compare with the super-affluent? Indications are that the higher one’s net worth, the better one is at minimizing one’s realized income. The fact is that the super-affluent got to that position by being masters at minimizing their realized income.
Ross Perot is the perfect example of how the super-affluent stay affluent and
(70 of 277)
even enhance their levels of wealth year after year. Forbes recently estimated that Mr. Perot’s net worth was $2.4 billion (see Randall Lane, “What’s Ross Perot Really Worth,” Forbes, October 19, 1992, p. 72). The Citizens for Tax Justice, a tax reform group headquartered in Washington, D.C., estimated that Perot’s annual realized income in 1995 was approximately $230 million. Thus, he realized the equivalent of 9.6 percent of his wealth but paid only $19.5 million in tax, or 8.5 percent of his income (see “How Perot Caps His Rising Taxes at Only 8.5%,” Money, January 1994, p. 18). Compare this figure with the 31.6 percent of their income paid in tax by Barbara, Sharon, and many others in their income category (see ‘Table 2-3).
How does Mr. Perot end up paying such a small percentage of his income in tax? According to a recent newspaper report:
Perot... minimizes his tax bill by investing heavily in taxfree municipals, tax-sheltered real estate, and stocks with unrealized gains (Tom Walker, “Perot’s Tax Rate Is Lower Than Most, Magazine Says,” Atlanta Journal-Constitution, Dec. 30, 1993, p. 1).
Of particular interest, Perot’s tax rate as a percentage of his income—that is, 8.5 percent—is lower than that of the average American household. The average household in this country pays $4,248 in federal income tax each year, or the equivalent of 12.9 percent of their annual realized income of $32,823. Perot is super-affluent in terms of accumulated wealth, but he has less than the common man’s marginal tax liability.
Even more interesting than the percentage of income paid in taxes is the percentage of wealth paid in taxes. The typical American household has a total net worth, including equity in the home, of $36,623. They pay the equivalent of 11.6 percent of their net worth in income tax. What about Mr. Perot, the billionaire? In one year, it is estimated, he paid the equivalent of only 0.8 percent of his wealth in tax. In terms of income tax paid as a percentage of wealth, the typical household paid 14% times more.
Most millionaires measure their success by their net worth, not by their realized income. For the purposes of wealth building, income doesn’t matter that much. Once you’re in a high-income bracket, say $100,000 or $200,000 or more, it matters less how much more you make than what you do with what you already have.
(72 of 277)
No comments:
Post a Comment