How the rich get rich [Long]

This is a discussion on How the rich get rich [Long] within the A Brief History of Cprogramming.com forums, part of the Community Boards category; I'm really lucky to work for a small software company that is owend by an ex-accountant and a stock broker, ...

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    How the rich get rich [Long]

    I'm really lucky to work for a small software company that is owend by an ex-accountant and a stock broker, both of them are very rich and have working with/for very rich people. I have lunch with them sometimes and they're teaching me a lot about the game of money and how the rich think differently to middle class and poor people. I figured I would like to bring it up here because it's a really cool topic and that by writing about it here I would (a) get a better understanding of it by explaining it myself and (b) get your feedback and views.

    Their basic idea is that the rich play the game differently to the poor. They know the laws better (or know people who do) and they know how to use the laws in their favour. Please bare with me while I explain - it really is an interesting subject and we could all (the younger the better) learn a lot!

    For instance, here in Australia the highest tax bracket is 45% of the dollar. So a person earning $100,000 usually loses about ~$40,000 of it as soon as he recieves his paycheck due to tax.

    For those that don't know, income and taxes basically go like this:
    Code:
    I get paid, lets say $50,000
    The government takes their share (say $15,000)*
    I am left with $35,000 to spend
    So a lot of ones income is lost straight away as tax. The more money you make, the more tax you are supposed to pay. "Rob from the rich and give to the poor".

    Lets say we want to invest in buying stock.
    Code:
    We save up $100,000. 
    We buy shares in a small startup company at $1 each
    The shares double over 2 weeks to $2.
    We sell our shares, and we have $200,000
    Pretty cool, so we just earned ourseves $100,000 in two weeks! Not so fast Charlie. First, that $100,000 is considered personal income, and the government takes its share of it in taxes. That leaves us with about $60,000 in profits, or about $160,000 all up. Still, thats $60,000 we didn't have before.

    So, we reinvest.
    Code:
    We buy shares in another company for a dollar each, using up our $160,000.
    We sell our shares again for $320,000.
    We just made $160,000 in profits, but again the government taxes it. They tax us say $60,000 this time, leaving us with $260,000. Still, thats $160,000 more than we started with.

    Now, this is the cool bit. This is where the rich play the game differently.

    Remember the rule above? Money comes in, gets taxed, then we get the rest? Well, Companies don't work that way. Companies have a whole different set of laws, but basically their cash flow goes like this:
    Code:
    Money comes in
    Expenses are paid first
    Whats left over is called "profit" and is taxed
    Expenses include anything from paying employees, reinvesting, buying merchandise to sell, anything the company needs to spend in order to make more money. The rules are differnent to companies to you and I.

    But this is the cool bit - companies cost about $1000 to set up, and a few hundred dollars to get an accountant to look at your books each year. You can have a one person company. A company is really just a piece of paper, but it can own stocks, have empolyees, and be sued. It is an entity by itself.

    So, I set up a company, called Paul Stovell Pty Ltd. that I will use to invest my money under.
    Code:
    I put my $100,000 in to stock again
    The price doubles and I get $200,000
    I take that $200,000, and reinvest it
    Holy crap!? What happened to the tax? Well, what happened was I reinvested the money earnt, just like I did in the other example. But, because I am a company, reinvesting is a business expense. So my company earnt $100,000, and spent $100,000. Profit = $0.0. Since my profit is 0, there is nothing to tax.

    After I reinvest, again the price doubles. I now have $400,000, and again I reinvest so as to not get taxed. Right now, my company owns $400,000 in stock, while the person above only has $260,000. **

    By avoiding tax, not only did I save on money from my first gains, but I had more to invest subsequently, making my growth rate higher.

    As you can probably tell, both the person and the companies money is growing at an exponential rate, but the companies is growing much faster. The company had to spend $1000 extra at the beginning to set up, but the money earnt certainly made up for it.

    There are a thousand other tricks like this that rich people know that middle class and poor people don't. These tricks are called your "financial literacy" - your understanding of the law, accounting, and investing. These subjects are not taught in school. Why? Because if everyone did this, the government would hardly make any money of taxes and the schools would have no funding.

    Another funny fact is this: The USA didn't always have taxes. The government wanted to introduce taxes, but to do so they needed the people to vote for it. So, they used the old "rob from the rich and give to the poor" mentality against the poor and middle class. They told them only the rich people would be taxed.

    But rather than get angry, the rich just got smarter. They looked for (or hired people to look for them) legal loopholes such as the one above to avoid paying tax. As more and more rich people learnt how avoid tax, the government had to lower the tax brackets until the poor and middle class were paying more than the rich people! The people who voted taxes in were the ones paying the most for it.

    Now you might be thinking, "isn't this illegal?". There are a lot of laws and regulations, and thats why it pays to know the law well. Thats part of being financially literate. Not paying taxes and not declaring income to the government is a crime. But avoiding and minimising the amount of tax you have to pay is perfectly legal.

    Conclusion
    Basically, the rich don't get rich because they are the smartest, or because they have great ideas. This sucks. The rich get rich because they understand the science of money. They love the game of money. The rich aren't afraid of losing, and they know enough (or know people who know enough) to tell a good investment when they see one.

    By expanding your "financial intelligence" - by understanding some very simple maths, basic accounting, getting a little experience with investing, and spending time looking at the markets (supply and demand) you will come much closer to being financially independant than if you just go through school and let that be the end of your financial education.

    Disclaimer: This is just what I've learnt so far. It doesn't constitute legal advice. I could be making the whole thing up for all you know. See an accountant.

    * Yes the figures are crazy, and one would be extremely lucky to make that sort of money in stocks their first time. It was just for an example. The truth is, the lower the figures and gains, the faster the rich get ahead.

    ** I understand that money belongs to the company, not me. To get the money out, I have to pay myself a wage or make drawings, and then I will be taxed at the 45% tax rate. But if I draw $400,000 and get taxed 45%, I'll still make more than the person who drew $260,000 and lost 45%. The point isn't about avoiding tax at the end - its about how rich people can make their money grow extremely fast using a company to reinvest.
    Last edited by nickname_changed; 05-02-2005 at 08:43 AM.

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    S Sang-drax's Avatar
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    Just reinvesting the stocks will not be taxed. It is when you spend the money the tax is calculated.
    Last edited by Sang-drax : Tomorrow at 02:21 AM. Reason: Time travelling

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    Correct, reinvesting the stocks isn't taxed.

    But when you sell stocks and make money from it, you have made money. Making money is a form of income, and income is taxable. Thats where you are taxed, even if you put the money in. I believe by reinvesting the money you make, you can claim it on tax and get some back, but you still lose money.

    My point wasn't so much about how great companies are, but how richer people generally know a lot of these things that us "common folk" don't. For most people, going to work, and working hard, are the only ways to make money. But even when they do make money, the majority of people don't know how to use it properly. Simply putting it in a bank (which is a very slow way of investing - say you earn 7% interest - do you realised that interest earned is also taxed?) and saving away is the only form of investing most people know. School never taught them that financial intelligence.

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    5|-|1+|-|34|) ober's Avatar
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    I've been doing some reading on some investing lately... how to get the most out of your investments, how not to get screwed, etc. It's quite interesting what you can do with a little bit of research and a little bit of timing.

    Another good financial tip: Most times, what you pay for an investment determines what you make from that investment.

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    Yes, my avatar is stolen anonytmouse's Avatar
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    Forget all this tax-minimisation stuff, I want to know which stocks double their value in two weeks!

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    Forget all this tax-minimisation stuff, I want to know which stocks double their value in two weeks!
    Take the easy way out. Just marry a feminist.

    Being a feminist, she's most likely spent her whole life determined to prove that she's better than man. So she's gotta have a pretty decent education and a wicked cool pay check.

    She's also more than willing to make you feel inferior and prove to the world that you're a failure of a lazy bum. Tell her you want to be a stay-at-home Dad.

    But then, families are soo old-fashioned. Let's not have kids!

    You'll retire after your honeymoon and spend your life playing Xbox with about 8 oz. of crushed Dorito crumbs on your face, and you'll still be stinkin' rich!

    If you could get like a way hot feminist, this could be my best theory since I proved that Operating Systems are just mirroring politics...

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    and the Hat of Clumsiness GanglyLamb's Avatar
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    @ sean_mackrory: And then she´ll give you this present

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    This reminds me of a joke I heard. "How do you make a million dollars and not pay any taxes on it?" The punchline: "Ok first you make a million dollars, and then..."
    The crows maintain that a single crow could destroy the heavens. Doubtless this is so. But it proves nothing against the heavens, for the heavens signify simply: the impossibility of crows.

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    Perhaps it should be how the rich stay rich..

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    Let's do some coding! Welshy's Avatar
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    Interesting read stovellp, investing seems to be well worth it if you know what your doing

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    Quote Originally Posted by anonytmouse
    Forget all this tax-minimisation stuff, I want to know which stocks double their value in two weeks!
    If you are risky, small startups just as they get on the market can be good investments apparently. It might not be two weeks, but I've seen prices go from $2 to $26 on less than 3 months.

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    unleashed alphaoide's Avatar
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    Quote Originally Posted by stovellp
    If you are risky, small startups just as they get on the market can be good investments apparently. It might not be two weeks, but I've seen prices go from $2 to $26 on less than 3 months.
    If it's risky then it's gambling; it's tossing a coin. Good investors don't do that. Grab some books and educate yourself. Start a paper portfolio (pretend that you're trading) and see what method you're comfortable with. And as important as knowing when to buy, know when to sell.
    source: compsci textbooks, cboard.cprogramming.com, world wide web, common sense

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    I have lunch with them sometimes and they're teaching me a lot about the game of money and how the rich think differently to middle class and poor people.
    It's impossible to have any discretionary money when you're only making between $7 to $10 an hour, which means for the poor, whether they think differently from the rich or not, cannot make the kind of investments the middle class and the rich are able to. The middle class might be able to make a few extra bucks, but then why would they care? They're doing all right. Why waste the effort to actively trade on the stock market?
    Last edited by okinrus; 05-04-2005 at 05:38 PM.

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    Quote Originally Posted by okinrus
    Why waste the effort to actively trade on the stock market?
    Why work 8-10 hours a day (like most of the middle class) 5 days a week (plus working from home, plus 1.5 hours travel, not to mention overtime) if you can spend a little time learning how money works and doing a little investing and building your assets and work half as much?

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    The max tax rate in Australia is actually 47%..

    http://www.ato.gov.au/individuals/co...u=5053&mfp=001

    Because of the sliding scale you get an actual tax rate lower than that. That is you get the first $6000 tax free.

    Companies pay 30% on every dollar earned.

    If you earn $50,000 you pay 24% tax as an individual and 30% as a company.
    No point in becomming a company until you ern about $70,000 (in Aust). Then you create a $2 company (has two shares each worth a $1)
    Not many employers will pay a company and if you earn over 80% of your income from one source then you are classed as an employee (not a contractor).

    Expenses incured as an individual (in generating your income) are also 'tax deductible'. This means you can reduce your net income by the expenses amount.
    If I earn $60,000 and spend $10,000 on PC, IDE and internet access (ect) I have a taxable income of $50,000 )


    Also look at property.
    If I put extra savings into my home loan I save 6.76% per year in interest. I don't pay tax on this saving (as opposed to putting it into interest earning account and paying tax on every dollar earned). The property also is increasing in value at 13% per year. I pay less in mortgage than many of my friends do in rent.
    Property is very low risk for good return.
    "Man alone suffers so excruciatingly in the world that he was compelled to invent laughter."
    Friedrich Nietzsche

    "I spent a lot of my money on booze, birds and fast cars......the rest I squandered."
    George Best

    "If you are going through hell....keep going."
    Winston Churchill

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