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The Billionaire Secret: Avoid Ordinary Income, Acquire Capital Gains

The key to building wealth is to build or buy an asset that can appreciate in value and/or generates passive income. The key to building or buying an asset that can do that is to convert your labor into capital (money). This is why saving for retirement, saving for a home, and saving in general is such an important piece of your personal finance plan.

This is the billionaire secret because this idea is well understood by people who are wealthy. They see that capital gains taxes are much lower than ordinary income, that’s why Warren Buffet pays lower tax rates than his secretary. Capital gains are taxed at 15% for 2010 while the 15% tax bracket is the second lowest federal tax bracket [3] (for those earning up to $34,000). It’s a no brainer, you want to transition, as quickly as possible, from ordinary income to long term capital gains and dividend income.

Turn Labor into Capital

One lesson I’ve learned in the years I’ve been writing about personal finance is that we are constantly turning our labor into capital. We are turning our time into money. When you’re young, most of your income will be the result of time and effort. As you accumulate more money, the money starts to work for you. A greater percentage of your income will come from your investments, rather than the hours you work during the week.

This is why it’s so important to save and put that money to work for you. If you work for 50 weeks a year for 40 years, that’s 2,000 weeks of work. If you assume a 40 hour week, you will work 80,000 hours before you retire. When you retire, your nest egg, a percentage of those 80,000 worked, has to generate income so that you don’t have to. Your time has to be able to buy more time. It can only do that if it generates income and it can do so at a lower tax rate.

Home Ownership

Home ownership was always lauded as the path to riches because it represented two things – shelter and capital gains. Unlike a share of stock, you can live in a house. It appreciates in the long term and you get immediate utility out of it, making it a fantastic investment and superior to renting, since you don’t get any appreciation when you rent. There are downsides to owning a home and many reasons why you shouldn’t look at your home as an investment [4], but ultimately it’s one of the most efficient ways of turning your capital into capital gains.

Bank Savings

One of these “investments” is your savings and the interest you earn from keeping it at a bank. While the 2% you can get at a high interest savings account [5] isn’t going to set you for retirement, that income represents your money working for you. The problem with this approach, at least for the long term, is that interest income is considered ordinary income. It’s taxed at the higher rate, which makes it a bad idea.

Dividend Investing

Dividend investing introduces a little more risk while moving down into the favorable tax brackets. While historical returns aren’t indicative of future performance, people look to the Dividend Aristocrats [6] and Dividend Champions [7] because they see stability. If you’ve been paying dividends for 25 or 50 years, you’ve seen through many a recession. There is risk in investing, even if it seems safe, because you never know when you’ll have a tragic oil spill and have to cut your dividend for the year (i.e. BP [8]).

Dividend income is set to be taxed as ordinary income after December 31, 2010. Also, I’m not advocating that you invest in the stock market or that you take on dividend investing, that’s simply the closest analogy to bank interest. I am merely suggesting another option that has a favorable tax treatment.

As an aside, many of the Bush tax cuts were considered a boon for the wealthy because of this principle. When long term capital gains and dividends were given favorable tax status, the people who benefited the most were the wealthy (or those who were in the financial services industry). Your average middle class family isn’t going to have a lot of taxable investments, most won’t have more in the market than what they have in 401(k) plans, which don’t benefit from a lowered capital gains tax rate. The capital gains tax rate is set to rise for 2011 [9] as the cuts will sunset after this year.

As we’ve accumulated more capital, I’ve been moving more and more of it into investment type of opportunities to shift more of our income from ordinary to capital gains. You need to be smart and analytical about what you decide to do with your money (putting money into a losing venture will save you $0 in taxes!), but it’s important to understand how the game works and this is exactly what the wealthy do.

(Photo: vatsek [10])