Making Money is Making Money...Right?

We tend to focus on “making money” to become wealthy, while necessary, it is only one small piece of the pie. Much more important, is the type of income you are generating and how you spend your income.  Before we can dive into income we need to define wealthy so we will know when we have achieved it. 

 

WHAT IS WEALTHY?

 

I have heard many definitions of wealthy, most of which are complex and require a financial dictionary to understand. To me, wealthy simply means I have more income from assets than I have in total expenses. In other words all of my expenses are paid for with the income collected from assets. This is a concept I was first exposed to reading Rich Dad Poor Dad 10 years ago and it resonated with me at the time and has stuck with me. In this definition my expenses drive my need for income. If I have very low living expenses, say $1,000/month, then I only need $1,000 from income each month to be wealthy. On the other hand, if I have extravagant taste, fancy cars, a big house and expensive vacations I will need a lot more income from assets to cover my expenses.

 

TYPES OF INCOME

 

To fully appreciate this definition of wealthy you need understand that there are 3 types of income.

 

Stick with me, sounds complicated but we are going to break it down so that even a preschooler or elementary student can understand it. Earned Income is money you make for performing a task or service. It is the money you work for. Your paycheck. Your allowance for performing chores. Money for mowing lawns. Lemonade stand money. The critical distinction is that if you are not present to do the work the income stops. If I do not mow lawns tomorrow, I will not get paid. If I do not sell lemonade, I will not make money. It is what most of us spend our time trying to achieve and what we help our kids obtain, however based on our definition of wealthy, regardless of how much earned income you make you can never be wealthy if this is your only source of income.

 

The other two types of income, Passive and Portfolio, is the money you receive regularly from your assets. Rather than drawing a distinction between passive and portfolio income, I want to draw a distinction between capital gains and cash flow income. These are the two ways to make money from assets. Capital gains come from buying and selling assets. For example if you buy a piece of silver for $25, hold it for a year and then sell it for $45 dollars your income is capital gains. The same would go for buying and selling real estate, stocks, bonds and businesses. While you can make big chunks of money from capital gains, it is not regular or predictable. Cash flow, on the other hand, is the regular money you collect from assets you own. For example it is the money you make on rental property, the quarters you collect from vending machines, the dividends you make from stocks, or the dividends you make from a business you own. It is more predictable and easier to plan for and should the primary income you try to achieve. I like to invest for the cash flow to pay the bills and the capital gains are “gravy on top”.

 

Now that we know they different types of income, let’s identify how you should spend each type of income your make. Earned income, once spent, is gone forever unless we get up tomorrow and go to work to earn more. This cycle is often referred to as the Rat Race. If this is how you spend your money you will wake up every day working for money. In order to become wealthy we want the money to work for us. In order for money to work for us we have to buy assets. We use EARNED INCOME to buy ASSETS. The assets will continue to produce money, even when we are not there. Now the money is working for us. We use PASSIVE and PORTFOLIO INCOME to pay for expenses (i.e. toys, nice cars, etc.) and to buy more assets.  

 

APPLYING IT AT HOME

 

Our son set up a lemonade stand on national lemonade day in May. His net profit (what he made after his expenses) was just shy of $150. With that money he tithed to his church and used the rest to buy a gumball machine. He put the gumball machine in a local restaurant. It was difficult for him not to immediately buy a great toy, but for his patience, he now collects quarters from his gumball machine every two weeks. Of that money, he tithes 10% to the church, saves 25% to buy more gumballs and spends the rest on whatever he wants. If he continues to buy machines and grow his business he will grow the amount of cash flow he makes each month and one day will have a business he can sell (capital gains). He will be able to use that money to invest in a new business or other assets. With an understanding of how money works, you can equip your children to avoid the rat race all together. Something that is unheard of in today’s society. What are you doing to give them the gift of financial freedom? Please share your thoughts and ideas here for the benefit of all us parents trying to equip our children.

 

For more on teaching your child about income, what it is, and how to apply it in their daily, check out the eBook A Day At The Carnival on Amazon.com. Subscribe to this blog our like on Facebook to be notified of future posts.

The Best Time to Learn About Money

I am often asked in jest what I would say if my son told me he wanted to be artist, cowboy, or any other stereotypical “lifestyle” career that is perceived to be accompanied by low pay.  Counter to what many assume, I am not trying to dictate or force a career path upon my son by teaching him how money work and financial concepts.  My goal is to provide him a sufficient financial education that when the time comes he can make a decision on career path with adequate knowledge.   

Most of us, including myself, made some of the biggest decisions in our lives when choosing whether or not to go to college, selecting our first job, and electing our lifestyle once we were “on our own”, such as, what car to drive, purchasing a career wardrobe, buying a house, etc.  What society teaches is that you should go to college, get a degree, find a safe secure job, buy a house as an investment, buy the car you “deserve”, and buy a killer wardrobe to look the part for your newly obtained job.  The result, $200,000 in debt in the blink of an eye, and that assumes you got through college without student loans.   Thus begins the rat race.  The next 20 to 30 years, if not the rest of your life, will be spent paying for those decisions and digging out of that hole.  If we had learned about how money works, the different types of income, the benefits and draw backs of each type, and the financial consequence of those decisions, we may have elected very different decisions.   With a solid financial education, we may have chosen exactly same decisions, but we would not have been surprised by the consequences of those decisions.   

My goal in teaching financial education is to empower people to make sound decisions based on knowledge.  The best time to make those decisions is before you find yourself in debt $200,000+. Since most of those decisions are made before we are 25 years old, I focus on educating children.  What are you doing to equip you and your  children with a sound financial education?