Tuesday, April 12, 2011

Why Do the Rich Get Richer and the Poor Get Poorer?

Robert Kiyosaki first introduced the idea of the Cash Flow Quadrants in his book Rich Dad, Poor Dad, but fully expanded the idea in his book Cash Flow Quadrant. The idea is that there are four ways of making money, as an Employee, Self-Employed, Business Owner or Investor.

Employee: Employees generate their income by trading their time for money, usually for someone else's business. If you get a W2 at tax time, and that signifies the majority of your income, you are an Employee. Employees generally get benefits, like health insurance, vacation, sick leave, etc. They usually work a certain number of hours a week and get a fixed income for that time.

Self-employed: The self employed is actually a very broad spectrum of careers. There are independent tradesman like plumbers and electricians as well as what many call professionals like doctors and lawyers. For tax treatment they can be a Schedule C, C-Corp, S-Corp, LLC or various forms of partnerships. They generate their money by providing goods and services to as many clients/customers as they can.

The Employed and Self-employed make up around 95% of the people, but they control only 5% of the wealth. They make their money by trading time for money.

Business owner: Business owners are often confused with the self-employed. The distinguishing factor is what happens to your income when you go on vacation. The self-employed are the business. A business owner's  business is run by a system, that works whether he is there or not. For instance, if you spend millions to buy a McDonalds, go to Hamburger University and then hire your managers, you're pretty much done spending time on your McDonalds business. You can go on vacation and the McDonalds' system keeps the business running.

Investor: Many people think they are an investor. They way you can tell is how you react when you lose $200 million in a transaction. Investors aren't phased. Investor's generally do not invest in mutual funds, and generally not in stocks like that average person does. There are even laws that favor the Investor, which prevent others from investing in some of the riskiest (and highest return) investments.

The Business owner and the Investor do not trade their time for money, but trade their time for raises. We all have the same 24 hours in a day, but the Employed and Self-employed are limited in their income because they trade their time for money, while the Business owner and the Investor trade their time for raises. Same 24 hours, but the Rich get Richer for every hour they invest.

Now you might think that the Poor (and shrinking middle class) would just maintain. Well, there are two things that are against them: inflation and thinking. Inflation makes the money that you have worth less. That means each year you have to increase the value of an hour more than the increase in inflation.

Robert Kiyosaki describe the thinking of the Poor, Middle Class and Rich in this way:

Poor: Every dollar they get goes to expenses. They trade their time for money and then trade their money for stuff. Robert calls this turning their cash into trash.

Middle Class: While some of their money is spent on stuff (expenses), a large portion of their money is spent on taxes and debt. The Middle Class buy what they think are assets (houses, cars, etc.), and the debt ends up sucking the money right out of their wallet before they really see it.

Rich: The rich invest their money in true assets. Robert Kiyosaki considers a liability anything that takes money out of your pocket (mortgage, loan, expenses, etc.) and an asset anything that puts money in your pocket. It's a simple test to see if it is an asset or a liability, and doesn't head-fake you into think you are doing great because you have lots of "assets." The Rich also pay less in taxes, due to how they earn their income. The income tax structure favors them. The Poor and Middle Class earn, are taxed and then spend the rest, while the rich earn, spend and then are taxed. Some of those tax advantages are available to the Self Employed.

I hope I've challenged your thinking on income, debt, taxes and finance. I think the more we can improve our thinking about money, and then act on that thinking, the better off we'll be.

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