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:
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".
I get paid, lets say $50,000
The government takes their share (say $15,000)*
I am left with $35,000 to spend
Lets say we want to invest in buying stock.
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.
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
So, we reinvest.
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.
We buy shares in another company for a dollar each, using up our $160,000.
We sell our shares again for $320,000.
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:
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.
Money comes in
Expenses are paid first
Whats left over is called "profit" and is taxed
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.
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.
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
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.
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.