Everything in personal finance seems to go around in circles. This post will discuss when income is more important than net worth for financial freedom.
In the past, I argued that it’s better to focus on net worth growth over income growth. Wealth is not taxed like income. Further, financial freedom is about living off your invested capital that generates passive income for life.
Given job income is the main source of income for the majority of people, by definition you’ll never truly be free if you mainly focus on income. Only when you build a large enough net worth can you truly be beholden to no one.
But over the past several years, I’ve noticed that focusing too much on net worth and not enough on income growth has created a scarcity mindset. Before I explain what I mean, here are eight reasons why focusing on net worth is important.
Reasons To Focus On Growing Net Worth
1) The government goes after income, not wealth.
We have a progressive tax system in America. The more you make, the more the government will take away. If you are in the top tax bracket in places like California, New Jersey, or New York, you will be pay a total federal + state marginal tax rate over 50%. But if you have $10 million dollars, the ideal net worth for retirement, that generates $200,000 a year in dividends, you only pay a 15% tax rate. But eventually, the government will go after your wealth beyond the $11.7 million mark per person in 2021.
2) Subsidized health care.
Under Obamacare, if you make more than 400% of the poverty level as deemed by the government, you no longer get subsidized healthcare. For singles, that income limit is roughly $46,000, and for families of three or four, that income limit is roughly $78,00 and $94,000 respectively. But imagine if your family of three has a $5 million net worth and nobody worked. You have no debt of any kind and all you need money for is food, clothing, and entertainment.
Let’s say out of your $5 million net worth, $3 million is an investment portfolio and $2 million is in real estate. Your $3 million stock portfolio produces $60,000 a year in dividends. Under the ACA, your family gets ~$3,500 a year in subsidy, despite being multi-millionaires. Meanwhile, a family of three earning $85,000 with 1/20th your net worth gets $0 subsidies. Hee’s a post on how to get healthcare subsidies, even as a multi-millionaire.
3) Alternative Minimum Tax (AMT) Exemptions.
The AMT exemption amount for tax year 2021 is around ~$60,000 for individuals and ~$90,00 for married couples filing jointly. The AMT hasn’t been adequately adjusted to catch up with inflation for years because the government knows this is a great way to generate more tax revenue from the middle class. Once you start making much more than $200,000 MAGI, you start paying a hefty amount of AMT.
4) Child tax credit.
The new enhanced benefits in 2021, provide for $3,000 in child tax credit, which specifically cover teens who are 17 for the first time. Th child tax credit is income-based and would start to phase out for individuals earning more than $75,000 a year or $150,000 for those married filing jointly.
From there, the credit would be reduced by $50 for every additional $1,000 of adjusted gross income earned. That means the $3,000 credit provided to parents of a child aged 6 to 17 would be phased out completely for individuals earning $95,000 and those making $170,000 and filing jointly.
A family of three with a $2 million net worth and income of $100,000 can get a child tax credit while a family of three earning $1700,000 a year with a $200,000 net worth can’t get anything.
5) Different wealth mindset.
If you have an income mindset, you’re likely a worker bee. If you have a wealth mindset, you figure out a way to build massive equity in your business or other people’s businesses for next level wealth. Some are now arguing that the only way to buy property and raise a family in expensive places like London, Hong Kong, San Francisco, and New York is through equity, not income. Unfortunately, this is becoming more and more true the longer this bull market lasts.
6) Net worth is more stealth.
Net worth can be spread across many different companies and investments. It’s much harder to calculate one’s true net worth than one’s income. Nosy people can guess a portion of your net worth through visible holdings like your primary residence and your vehicle. But they will have an impossible time figuring out the whole thing. For folks who like privacy and following the Stealth Wealth mantra, net worth is much more important.
7) Less temptation to spend wastefully.
Income usually comes in a regular bi-weekly or monthly cadence. Each time there’s an injection of income, there’s a temptation to spend. There’s a reason why casinos are much more full during the middle and end of the month.
Your net worth is much more complicated and much less liquid. As a result, there’s much less temptation to pilfer your net worth for short-term desires. For example, I can’t withdraw from my private equity funds without paying a penalty. It also takes a lot of preparation to sell a property. With income, I can spend it instantaneously.
8) Higher feeling of security.
The feeling of security might be the biggest reason to focus on building a large net worth vs. building a large income stream. Everybody’s number is different, but I promise you that you will feel much more secure once you reach your wealth number vs. once you reach your income number.
Your net worth is generally much more sticky if you properly diversify. Your income can be extremely volatile, especially if you are in a revenue producing role where a bonus makes up a large percentage of total compensation. You can lose 100% of your income one day, but it is unlikely you will ever lose your entire net worth, unless you were over-leveraged.
Why Net Worth Might Be A Scarcity Mindset
So why can focusing on net worth be considered a scarcity mindset? The main reasons have to do with taxation and receiving government benefits.
By keeping your household income low, a lot of people can pay less than a 10% effective tax rate. Some households can essentially pay nothing due to child tax credits, pre-tax retirement contributions, exemptions, and deductions (standard or itemized).
Paying little to no taxes is fine, but it essentially means you’re too poor to financially contribute to the health of America. I know so many people who purposefully stop working, give up their side hustles, and physically let themselves go due to the desire to minimize taxes and get government healthcare subsidies. They’ve completely limited their potential.
Wouldn’t you much rather pay $100,000 in taxes and keep $200,000 than pay $5,000 in taxes but only keep $36,000 a year? I sure as heck would.
Minimizing our tax burden is one of the most important exercises given the government is so wasteful with our tax dollars. But purposefully limiting your income potential in order to pay less taxes and receive subsidies is backwards looking.
Income Growth Mindset
Between the age of 22 – 34, I had an income mindset. An income mindset is what made me take the risk of moving from NYC to SF with a new firm. Despite not knowing anybody in SF, the pay was too good to pass up. An income mindset is what made me work longer hours to get promoted faster. By shoveling up to 80% of my after tax income into investments for 13 years, an income mindset ultimately allowed me to exit the workforce early.
But after I left the workforce, my entire money ideology shifted towards a net worth mindset because I wanted to take a break and preserve capital. In essence, a net worth mindset reflected a burnt out man who didn’t want to hustle any longer. Related: One Of The Biggest Financial Mistakes Early Retirees Make
From age 34 – 36, my investments returned more than my income not because my investments were so great, but because my income fell by 80% after I left the working world. If I had not completely forsaken the income mindset, I would be in a financially better position today.
Publishing investing lessons from a surreal 2017 illustrated how important it is to focus on income growth. Contributions equaled 10X my expected annual return. In other words, even if there was a 50% decline in my investment returns, I could get back to even in six months time with continuous contributions.
Put it another way, investment returns are no longer the driving force behind my net worth growth, income growth is once again. It’s like going back to my 20s, but with larger dollar amounts at work. Being able to actively contribute to your net worth is huge.
Benefits Of An Income Mindset
Here are times when focusing on income is more important than net worth.
1) Helps eradicate laziness.
After a certain point, holding on to a net worth mindset is due to laziness. With an income mindset, you’ll always be thinking about ways to generate extra income for you or your family’s financial security. Once you’ve reached your net worth target, all the more reason to try something new. There are some people who work less than 40 hours a week and complain why hey can’t get ahead!
2) Provides a tremendous investment buffer.
Although the investment environment has been wonderful since 2009, having an income mindset allows you to continuously build your nest egg in downturns. Your income becomes most powerful when you can contribute more each year than the amount you could realistically lose each year, e.g. contributing enough in 2008 so that you are even in your stock portfolio even though the S&P 500 declined by 36.55%. During good times, you can run up the score.
3) Keeps you active and healthy.
To make money you need to interact with people. When you interact with people, sometimes you make friends and stimulate the mind. I’ve found that doing private 1X1 consulting, corporate consulting, coaching high school tennis, attending meet ups, and eating steak dinners with business partners have all helped keep me active and healthy. Often times the camaraderie is even more important than the money.
Once the pandemic is over, there will surly be an explosion of economic activity! We just need to make sure we maintain the ideal body weight so we don’t die young!
4) More immediately fulfilling.
Another reason to focus on income growth over net worth growth is that it’s more fulfilling to generate active income.
There are less grey areas when it comes to measuring income than when it comes to measuring net worth. For example, there’s a +/- 15% valuation range for my real estate portfolio, and likely a +/- 50% valuation range for my online business.
With income, what you see is what you get, and it’s likely all due to your effort. There’s something very fulfilling with earning more after trying harder. A strong correlation with effort and reward is why entrepreneurship is so rewarding, and why working at a big corporation or the government may be less fulfilling.
Here is the recommended split between active income and passive income for greater happiness.
5) Easier to demonstrate a good work ethic.
If you’re a parent, an income mindset will help you consistently demonstrate a strong work ethic so your children don’t grow up to be entitled brats. A strong work ethic will also engender admiration from your partner, friends, and family members. The more people respect you, the happier you will be.
Now that I have two young children, I really like alternating my time between work and playing with them. It feels good to tell my children daddy needs to go work to make money so they can eat and have their toys. Working to make more income will hopefully enable children to appreciate the value of time and money. I’m excited to help build their custodial Roth IRAs and get them to work as well.
Retirement Is A Curious Thing
I always thought that I’d live off my passive income and be done with this work thing. But early retirement has a funny way of letting you focus on things you really enjoy doing. In my case, it’s writing about personal finance online and being a stay at home dad.
Sometimes, you get so utterly enamored with your passion project that you unexpectedly make a healthy income. When you earn something unexpectedly, that’s when you finally feel rich. Now I’m back to investing most of my income in assets that will hopefully generate enough passive income to take care of my family forever.
Net worth is still more important than income when it comes to financial freedom. Just don’t get carried away by completely forsaking your income generating abilities once you’ve achieved a comfortable number, especially during a bull market. At least find ways to make money through activities you truly enjoy. Who knows. You might surprise yourself one day!
Recommendation To Build Wealth
Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. You can use Personal Capital to help monitor illegal use of your credit cards and other accounts with their tracking software. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing.
I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management. At the end of the day, it’s good to focus on growing net worth and income. Eventually, you’ll want to spend your money on a better life for you and the people you care about.