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Many high earners' spending commitments match their income.
Many people confuse income with wealth. They are not the same thing, and failing to appreciate the difference will put you at a disadvantage.
Wealth is acquired by spending less than you earn and then saving and/or investing the difference. Even if you acquire wealth through inheritance or marriage, it still will have come from someone else having spent less than they earned at some stage.
In contrast, income is produced by labour and wealth that has been invested in income-producing assets such as bank accounts, property and shares.
Some high-earners are not wealthy
Many people claim that raising income tax rates is a good way to target the wealthy, and they use this to justify the 50% rate of income tax.
Aside from the fact that many people react to higher tax rates by arranging their affairs so as to reduce or eliminate their additional liability when taxes are raised, the correlation between income and wealth isn't quite as strong as you might believe.
Just because a person has a high income, it doesn't necessarily mean that they are wealthy. That's because many high earners have a lifestyle that makes it hard for them to turn their income into wealth. They have acquired a set of spending commitments which ensures that pretty much everything they earn is spent, leaving little or nothing at the end of the month.
Wealthy people don't necessarily have a high income
A surprisingly large number of wealthy people have fairly low incomes; most notably those who bought houses in the 1960s and 1970s before prices took off. They are the "asset rich, cash poor", and if a genuine wealth tax is introduced, such as a tax on house prices above a certain threshold, many of them won't have the income to spare to pay it.
We saw a good example of this last week when the journalist Joan Bakewell wrote in the Daily Telegraph about how she would probably have to sell her house if a 'mansion tax' was introduced because she didn't currently earn enough to pay it.
Now, while an asset like an expensive house can be turned into cash either by selling it or using it as security for a loan, I'm sure that the supporters of a mansion tax aren't doing so because they want to deliberately force some people out of their homes.
Convert income into wealth
Income can easily be turned into wealth. All you have to do is spend less than you earn, then save and invest the difference. It really isn't any more complicated than that and, if you spend a lot less than you earn, it can accumulate surprisingly quickly.
Charlie Munger, vice-chairman of Berkshire Hathaway, advises people to underspend their income, especially when they are young. It's a good habit to develop and, as Berkshire's chairman Warren Buffett likes to reminds us, "Chains of habit are too light to be felt until they are too heavy to be broken."
When I worked in the City of London for a few years it wasn't difficult for me to save 40% of my income after tax, mostly because I acquired the habit of saving at least 10% when I first started work. And on the rare occasions when I was paid a bonus, all of it went into the stock market instead of being spent on consumption.
For people who spend everything by the end of the month, the only way they can save and thus acquire wealth is by committing to a regular savings plan. The most common ways of doing this are by taking out a repayment mortgage and putting money into a pension fund and/or a stock market-linked savings plan. Doing this means that this part of their income is no longer available for spending upon consumer goods.
Ultra-high income bankruptcies
A surprisingly large number of highly paid professional sportsmen and women are not wealthy. The best example comes from American football, where roughly three-quarters of National Football League (NFL) players are declared bankrupt within two years of retiring from the game -- even though the average annual salary in the NFL is £1.2 million a year!
There are several reasons for this. There's a culture within the NFL that seems to cause players to make very bad investment decisions, most notably overinvesting in highly speculative property deals that go wrong. It's also very common for players to hire advisors who rip them off.
The high income that an NFL player earns makes it very easy to acquire expensive spending habits that will be hard to support when their income falls in retirement. Combine this with their limited work skills outside of the game, a divorce rate close to 75% (another huge cost), and their high bankruptcy rate isn't such a surprise.
A wealthy NFL retiree will have accumulated a substantial pool of assets to generate a decent income after their playing career is over.
Furthermore, by seriously underspending their income during their playing career, as Munger suggests, then they won't acquire too many expensive habits that could otherwise torpedo their finances in retirement.
BY Tony Luckett
http://www.fool.co.uk/news/investing/2012/03/13/dont-confuse-income-with-wealth.aspx
Many people confuse income with wealth. They are not the same thing, and failing to appreciate the difference will put you at a disadvantage.
Wealth is acquired by spending less than you earn and then saving and/or investing the difference. Even if you acquire wealth through inheritance or marriage, it still will have come from someone else having spent less than they earned at some stage.
In contrast, income is produced by labour and wealth that has been invested in income-producing assets such as bank accounts, property and shares.
Some high-earners are not wealthy
Many people claim that raising income tax rates is a good way to target the wealthy, and they use this to justify the 50% rate of income tax.
Aside from the fact that many people react to higher tax rates by arranging their affairs so as to reduce or eliminate their additional liability when taxes are raised, the correlation between income and wealth isn't quite as strong as you might believe.
Just because a person has a high income, it doesn't necessarily mean that they are wealthy. That's because many high earners have a lifestyle that makes it hard for them to turn their income into wealth. They have acquired a set of spending commitments which ensures that pretty much everything they earn is spent, leaving little or nothing at the end of the month.
Wealthy people don't necessarily have a high income
A surprisingly large number of wealthy people have fairly low incomes; most notably those who bought houses in the 1960s and 1970s before prices took off. They are the "asset rich, cash poor", and if a genuine wealth tax is introduced, such as a tax on house prices above a certain threshold, many of them won't have the income to spare to pay it.
We saw a good example of this last week when the journalist Joan Bakewell wrote in the Daily Telegraph about how she would probably have to sell her house if a 'mansion tax' was introduced because she didn't currently earn enough to pay it.
Now, while an asset like an expensive house can be turned into cash either by selling it or using it as security for a loan, I'm sure that the supporters of a mansion tax aren't doing so because they want to deliberately force some people out of their homes.
Convert income into wealth
Income can easily be turned into wealth. All you have to do is spend less than you earn, then save and invest the difference. It really isn't any more complicated than that and, if you spend a lot less than you earn, it can accumulate surprisingly quickly.
Charlie Munger, vice-chairman of Berkshire Hathaway, advises people to underspend their income, especially when they are young. It's a good habit to develop and, as Berkshire's chairman Warren Buffett likes to reminds us, "Chains of habit are too light to be felt until they are too heavy to be broken."
When I worked in the City of London for a few years it wasn't difficult for me to save 40% of my income after tax, mostly because I acquired the habit of saving at least 10% when I first started work. And on the rare occasions when I was paid a bonus, all of it went into the stock market instead of being spent on consumption.
For people who spend everything by the end of the month, the only way they can save and thus acquire wealth is by committing to a regular savings plan. The most common ways of doing this are by taking out a repayment mortgage and putting money into a pension fund and/or a stock market-linked savings plan. Doing this means that this part of their income is no longer available for spending upon consumer goods.
Ultra-high income bankruptcies
A surprisingly large number of highly paid professional sportsmen and women are not wealthy. The best example comes from American football, where roughly three-quarters of National Football League (NFL) players are declared bankrupt within two years of retiring from the game -- even though the average annual salary in the NFL is £1.2 million a year!
There are several reasons for this. There's a culture within the NFL that seems to cause players to make very bad investment decisions, most notably overinvesting in highly speculative property deals that go wrong. It's also very common for players to hire advisors who rip them off.
The high income that an NFL player earns makes it very easy to acquire expensive spending habits that will be hard to support when their income falls in retirement. Combine this with their limited work skills outside of the game, a divorce rate close to 75% (another huge cost), and their high bankruptcy rate isn't such a surprise.
A wealthy NFL retiree will have accumulated a substantial pool of assets to generate a decent income after their playing career is over.
Furthermore, by seriously underspending their income during their playing career, as Munger suggests, then they won't acquire too many expensive habits that could otherwise torpedo their finances in retirement.
BY Tony Luckett
http://www.fool.co.uk/news/investing/2012/03/13/dont-confuse-income-with-wealth.aspx
