Wealth vs. Income: Examples

[canyonwalker]

A few days ago I wrote a blog, Wealth vs. Income. I employed the analogy of a faucet pouring into a bucket of water to compare and contrast the two terms. The amount the faucet is pouring into the bucket is income; the amount in the bucket is wealth. At the end I hinted a third element of the analogy: a hole at the bottom of the bucket. In this simple analogy that hole is expenditure. (It's also losses, but let's keep it simple.) At the end of the blog I promised that understanding wealth vs. income helps explain a variety of real-world situations that many people are confused about. Here are Five Things:

"Tax the Rich"

Possibly the biggest misunderstanding of wealth vs. income in in popular expectations of who pays tax and how much. "Tax the rich!" you'll hear as a political slogan. "A tax on the wealthy!" Remember that what's being talked about in these discussions is income tax. It's right there in the name— it's a tax on income, not wealth. The wealthy do tend to have more income, though that's only a tendency. High income taxes also affect high earners, whether or not they're wealthy. That's the upper middle class tax squeeze.

Is there such a thing as a wealth tax? Yes, but it's not as common as income tax. In many states in the US there are property taxes. These assess a tax burden on the value of real estate. Not all states have such taxes, though. And many that do have loopholes the wealthy can afford the accountants and lawyers to exploit to reduce their taxes. Of course, real estate is hardly the only form of wealth. There's no tax in the US on stock ownership. Among the 38 OECD countries only a few have a wealth tax that applies to more than real estate.

Who's the 1%? Two Definitions

Alongside sociopolitical discussions about taxation is the term The 1%. The top 1 percent of what? Income and wealth are two different measures. A variety of articles you can find easily online will tell you that the threshold for top 1% by income is about $600,000. If you make that much or more annually, you're in the top 1% by income. That number includes some dual-professional income families, not all of whom would describe themselves as absurdly rich. While an income of $600k certainly isn't poor (or even middle class) it disappears pretty quickly when 35+% of it disappears to income and payroll taxes, then to a big mortgage and all the costs of supporting a family in a high-cost area (see below).

Contrast that to the top 1% by wealth. The threshold there is $10 million. Having wealth of that magnitude puts one in a very different situations from the $600k earner. Yes, earning $600k enables you to build wealth over time— especially if you're able to save and invest a lot of that annual income— but even so it can take years, decades really, to save and invest your way to $10 million. Thus when talking about "The 1%" as a label for the very rich, we should be talking about the 1% by wealth, not 1% by income.

Living Richly vs. Being Wealthy

Another way in which wealth is commonly misunderstood is via the appearance of wealth. Many people earn good income and spend it all— on big houses, fancy cars, trendy fashion, elite schools for the kids, Instagram-worthy vacations, and always having the latest gadgets and toys. To be sure, people who can afford this kind of lifestyle are living richly. But they may not be wealthy. They're the high income earners who are still living paycheck to paycheck. They may even have negative wealth— more debt on home loans, auto loans, and credit cards than assets.

Do you know Henry?

Sometimes a person with an objectively high income may not be wealthy or even have the money to spend on the appearance of being wealthy. Meet HENRY— High Earner Not Rich Yet.

Most Henrys are well employed young professionals. They're earning salaries that put them among, say, the top 10% of earners, but they're struggling to pay bills— and it's not necessarily because they're living extravagantly as in the previous example. Part of that is because Henrys tend to live in high cost of living cities. That's because the high paying jobs are mostly in expensive cities.

I was in this situation myself years ago. Like many young professionals just starting out, I had student loans to repay in addition to other costs of getting started in adult life, such as furnishing one's own house or buying a car. I had a good starting salary but I was also starting from nothing. ...Actually less than nothing; I had thousands in debt.

First I paid off my debts, which took several months in addition to living frugally. Then I started upgrading my lifestyle, a bit at a time so as always to be under-spending my income. It would still be 20 years before I achieved anything I'd recognize as wealthy. And by many standards I'm not wealthy yet. I certainly don't have the $10 million entry fee for the 1%. I don't even have a fancy car or a big house. The most Hawk or I ever spent on a set of wheels was about $35k, and we still live in a two-bedroom townhouse.

The House-Poor

So far I've mostly talked about people who have good income but not (yet) significant wealth. On the flip side of that tradeoff are those with lots of wealth but poor income. One relatable life situation in this category is the senior citizen who has a lot of value tied up in their house and little income. One of my grandparents was in this situation. The value of her house put her not in the top 1% but, say, in the top 5%. Other than living in a huge and well furnished house, though, she had little wealth. The income she drew from Social Security and from dividends on a small investment portfolio were enough to afford a modest lifestyle.