How do people get “rich”?
It’s a question I see almost constantly in popular culture, both directly and indirectly. It’s a constant theme on networks like CNBC and Fox Business News. It’s a big part of countless television commercials, news programs, magazine and newspaper articles, and even entertainment programming. It’s the subject of endless classes, books, and conversations, too.
Many seem to assume that it’s impossible for the average person to get rich without an obscene amount of luck (which isn’t true at all). Others seem to believe it takes wealth to become wealthier (which is sort of true, but not entirely). Still others attribute it to hard work, more than the average person is willing to produce, and to smart work (which is absolutely true). Another common idea is that it’s all about maximizing investment secrets and insider knowledge (not really true).
The truth is that the elements of building significant wealth – enough to live out the rest of your life – are in the hands of every person, but they require a number of ingredients. You need hard work. You need smart work. You need self control. You need patience and time. You need to be responsible for your own choices, good or bad. You need to accept your own faults and the challenges of your current situation, and try to make the best of the hand that you’re dealt.
Those ingredients form the bedrock for almost every method used to create wealth. Here’s exactly how wealth is created by almost everyone who doesn’t inherit it.
#1: Cut personal spending and control lifestyle inflation.
Right here, right off the bat, is the step that causes 76% of Americans to fail. It’s true – 76% of Americans are living paycheck to paycheck, which means that they’re spending every dime they bring in. All that a person has to do from that point is to simply cut back on their spending so that they’re spending less than they earn and have some left over with which to build wealth, but three quarters of Americans don’t do this.
Spend less than you earn. It’s the absolute key to every financial success a person will have in life. As long as you’re spending less than you’re bringing in, your finances are going to head in the right direction. The lower your spending is compared to your earnings, the faster it’s going to happen.
Here’s the reality of things. Let’s say you choose to save 10% of your income. What that means is that you’re just cutting out the bottom 10% of your spending – the 10% that’s the least important and the most wasteful of all of the ways you spend your money. Things like shopping at the convenience store or buying a book you won’t read anytime soon. However, that 10% turns into money you have every single paycheck with which to get rid of debts, to start investing, and to build wealth.
What do you do if you can’t possibly cut spending, though? (With a few exceptions, you probably can, but are unwilling to make the cuts.) Another key is to keep your spending level even as your income goes up. If you get a 10% raise at work, just keep your existing spending level, and you suddenly have that extra 10% to pay off debts and to invest for the future. Allowing your spending to rise with your income is called lifestyle inflation, and it’s something that literally three out of four Americans fall prey to. It’s also why three out of four Americans immediately remove themselves from the equation when it comes to building wealth.
- Related: Keeping Lifestyle Inflation at Bay
#2: Work hard to maximize personal income.
So, as I noted above, one sure way to have money to save and invest for the future is to keep your spending level steady while your income goes up. Thus, it’s unsurprising that the second strategy is to increase your income.
This is the other half of “spend less than you earn” – increasing income. The more you earn, the more resources you have not only to live on but upon which to build wealth and become rich.
So, how do you do that? You can focus on your current career, for starters. Make it a personal goal to become a top performer at your job and move up the career ladder. Don’t just look at your job as “hours for money” unless your current job is not your primary focus for earning income. If it is – give it your focus and give it your all.
At the same time, dabbling in entrepreneurship in your spare hours can end up paying some incredible dividends, too. A side business can earn a lot of money and can, on occasion, wind up supplanting your main job and earn you more than you ever dreamed.
The goal of both of those things is the same: to improve your personal income. If you pair that along with a commitment to not increase your spending as your income goes up, you’re going to have leftover money. It’s that leftover money that will open the door to building wealth, which is what the remaining principles in this article focus on.
- Related: How to Make More Money
#3: Eliminate high-interest debt.
The absolute first thing anyone should do with their leftover money (see the first two points if you’re unsure about this idea) is to use it to eliminate their high-interest debt. I define high-interest debt as anything with an annual interest rate of 8% or higher. No investment can routinely beat the “return” you can get from simply paying down these debts.
Debts with a high interest rate devour your money. You’re essentially handing money to them for virtually nothing in return except for the “benefit” of buying things a bit sooner than you could actually afford them.
How do you do this? I usually suggest that people follow what I call the “debt fireball” – make minimum payments on all of your debts, then throw the biggest possible extra payment you can at whatever debt has the highest interest rate. Soon, that one will be toast, and you can move on to the next debt down the list. Keep repeating this until you’ve toasted all of your debts.
When you’ve done that, you’ll suddenly have a ton of money available to invest each month. That’s the very point where you need to remember the first principle of becoming rich – avoid lifestyle inflation. If you suddenly decide at this point that it’s okay to spend more and inch your spending up toward most or all of your income, you’re going to quickly find yourself back where you started: unable to build wealth, because you have nothing to use to make it happen.
It’s true: You need money to make money, and the first three steps get you to the point where you have that money to invest. It just takes willpower not to escalate your spending to devour all of it.
#4: Use tax-advantaged accounts for investing.
One of the first strategies for becoming rich is to use tax-advantaged accounts for investing, like a 401(k) or a Roth IRA. The goal here is to minimize the amount of taxes you pay by simply doing things with your money that the government encourages and which benefit you personally.
There are a lot of ways to do this.
Your 401(k) at work, for example, allows you to avoid paying taxes this year on all of the money you contribute. Your overall taxes go down for the year, which means that for every dollar you contribute to that account, your annual income tax bill will go down by $0.20 or $0.30 (depending on your exact tax rate), which means that you’ll be able to put that money in your pocket. You’ll have to pay income taxes when you take the money out in retirement, but at that point you’ll likely be in a lower tax bracket, so you won’t have to pay as much.
A Roth IRA works in the opposite way. You put money in that account that you’ve already paid taxes on, but when you take the money out in retirement, you don’t owe a dime in income taxes on any of it, not even the investment gains you accumulated along the way.
A 529 college savings account is very similar to a Roth IRA, but with much higher contribution limits, and the money you take out is tax-free only if you use it for educational expenses — like, say, your child’s college tuition, fees, or books.
A health savings account, or HSA, is also similar, except you use the money for healthcare expenses, from co-pays to deductibles.
All of these accounts serve the same exact principle – they lower your taxes by taking advantage of areas in which you want to use your money and the government wants you to use your money. They provide tax incentives for you to do so and, for you, that means tax savings, which means free money in your pocket, either now or later on.
#5: Take advantage of free money.
Some employers take this concept even further and offer what amounts to free money to their employees for making smart choices. Some employers offer matching contributions into their 401(k), and a few even do this with HSA accounts.
You need to be grabbing every free contribution you can from your employers. If they offer matching contributions, contribute enough so that you can gobble up every dime they’re offering. If they just give you contributions into an account, make sure you’re signed up to get every dime of it.
This is essentially a free boost to your salary. It’s a very easy way to increase your income without any effort at all, so you need to be taking advantage of these kinds of offers from your employer.
If you’re not sure whether your employer offers anything like this, contact your human resources department and ask! Simply ask whether your employer offers any contribution matching for retirement or healthcare savings. If they do, then do whatever you need to do to get every dime of it.
#6: Reinvest dividends (and other investment income).
If you’ve followed the first five steps, you’re likely debt-free and spend substantially less than you earn. That’s the exact position that you need to be in to start building real wealth. It’s also a position that most Americans can attain. Unfortunately, it’s a position that most Americans will never attain because they ignore or struggle with the first five steps.
If you’ve reached this point, it means that you have a significant amount of money to invest each month. How do you invest it?
Well, you’re going to get a lot of ideas here, and different ideas are going to appeal to different people in different situations. Maybe you want to consider buying rental properties. Maybe buying stocks makes sense to you. Maybe you want to invest in yourself and get a better education to earn even more money.
No matter what you choose to do, eventually that investment is going to return some money to you. Your rental property will start producing income in the form of rent payments (after you’ve paid for insurance and property taxes and so on). Your stock investments will start paying dividends. Even your better education will start paying out in the form of a higher salary.
Take that income that you’re earning thanks to your investments and reinvest it. Rather than pocketing that rent check or those dividends, roll that money right back into stocks or into buying your next rental property. Don’t spend it. Don’t even think of it as real income. Just reinvest it, every dime of it.
This turns into an investment snowball over time. Not only are you continuing to contribute out of your personal income, you’re also contributing to your investments out of your investment income. That means the growth of your income will accelerate. Your investment income will grow and grow, which means that your contributions will grow and grow, which means that your investment balance will grow wildly.
#7: Hold investments for a while.
Let’s talk about taxes again.
You’ve probably heard about capital gains tax. It’s a political football that we won’t talk about in detail, but it is an important piece in understanding how people build wealth.
Capital gains tax is the taxes you pay when you sell something you own for a profit. Maybe you’re selling some stock that went up in value. Maybe you’re selling a rental property. Whatever it is, you sold something for more than you bought it for, and you have to pay taxes on the money you gained. You bought a property for $200,000 and are selling it for $300,000, so you have to pay capital gains tax on $100,000. That eats into your gains.
Now, there are two types of capital gains tax – short-term and long-term capital gains tax. The exact tax rate on each varies, but the long-term rate is virtually always lower than the short-term rate. You become eligible to pay the long-term rate when you hold onto your investment for a while – longer than six months most of the time, but we won’t worry about the nuance here.
Simply holding onto your investments for a while means that when you do sell them to collect the profits from the increase in value, you’ll get to pay a lower tax rate on that money. In fact, most of the income that wealthy people earn comes from selling things and paying only long-term capital gains tax on the sale. That means that even though they might be making a boatload of money, they’re only paying a rather low tax rate on all of that money – far less than if it was ordinary income.
This is how the government encourages people to invest and hold onto their investments, which is how the economy grows over time. It’s completely legal – and it’s an incredibly powerful way to build wealth, since you’re not paying very much in taxes.
#8: Hold investments forever.
The other option, of course, is to never sell your investments at all. You buy things solely for the purpose of owning them forever because they pay out a healthy amount along the way.
For example, a person might identify a company that pays a great dividend on their stock and is really stable – say, Coca Cola, for instance, a favorite of Warren Buffett’s – and they buy shares in that company with the intent of never selling those shares. They plan on sitting on those shares for life and just collecting the dividends. A person might do the same thing with a rental property, too – they buy it because it will earn a lot of rental income for the price of the property, so they intend to just sit on it for the rest of their life and collect the income.
If you do it this way, you never have to face any sort of taxes on the sale. Instead, you just collect passive income from here on out. You can keep reinvesting that income and you can add more to the pool from your own professional work, and then invest all of that to earn even more passive income.
This is how many people reach financial independence. They have enough sources of passive income – investments they’ve bought that pay out money and which they never really intend to sell – that they can live off of that passive income.
Usually, at that point, people do keep working, but they switch careers into something that brings them personal joy since the income isn’t nearly as important any more.
#9: Invest in yourself.
Another option for investing that I briefly touched on earlier is the idea of investing in yourself. If you’re spending less than you earn, you can take some of that money and improve yourself in various ways, particularly ways that have the potential to increase income in the future.
You can use that money to earn a better college degree or job certifications. You can use that money to pay for coaching or lessons to help you master a new skill or shore up an area in your life in which you’re weak. You can use it to fix cosmetic concerns with orthodontic equipment or Lasik surgery, giving you more confidence.
The goal of all of these things is not only to improve your personal confidence and skills, but to use those newfound elements to improve your professional income, which you can then use to build your wealth even faster.
#10: Invest your windfalls.
Sometimes, life will dump some money in your lap. An older relative dies. You win a prize of some kind. You find an opportunity to flip an item quickly for a big unexpected profit.
Whatever it is, you suddenly find yourself with a nice amount of unexpected money on your hands… and it can be very tempting to spend it on something fun.
Don’t. Treat it just like you would any other income that’s above and beyond your spending level.
Use it for your debt fireball. Use it to invest. Use it to accelerate your journey toward owning a rental property. Use it as a way to take a bunch of steps at once toward your long journey to wealth.
Windfalls are a great thing, but they can easily be wasted. Don’t let that happen. If a windfall comes along, use it smartly.
And, lo and behold, we’re right back at the beginning of this article – and we’re back at the one point that really, really matters when it comes to building wealth.
Spend less than you earn – and avoid lifestyle inflation even as your income goes up.
If you manage to do that one thing – and it’s the one thing that the vast majority of Americans fail at – then you’re going to be all right when it comes to your financial future. When it comes to starting from scratch and building wealth when you start out with nothing, there’s nothing more important than that one rule. Everything else follows from it.
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