Financial Case Study | High Earner vs. The Smart Investor

It’s not about how much you make. It’s about how much you keep.

If you’ve read my past posts, you know I’m an advocate of expanding one’s income through multiple income streams. You’ve probably even seen me battle with Scott Trench on the concept and value of frugality. Will avoiding your morning Starbucks run really make a noticeable impact?

Unfortunately, I have to give in a bit on the concept of frugality. You see, as I look for places to house hack around the DC-Metro market, I’ve come to realize I inherently understand that living frugally is a key part of the wealth building formula, no matter how much I hate to admit it.

The Pareto Principle

Even though I’m giving in to the concept of frugality, I view it somewhat differently. I prefer to find ways to minimize my big ticket expenses rather than cutting back on the morning latte. I strive to follow the Pareto Principle, where 80% of my savings will come from 20% of my effort. By forcing myself to avoid my latte, I save maybe $20 a week or $80 a month—the effort is not worth the savings, to me at least.

On the other hand, I can dedicate 20% of my week to finding a great multifamily property that will reduce my monthly housing expenses. Do you know how much it costs to live in DC if you have a car (a 10-year-old beater car at that)?

You may not, so let’s break it down: $1,300 in rent, $150 in utilities, $150 in parking, for a total of $1,600 every single month. Oh, and I have a roommate, so the above is only my HALF of our total expenses. Compared to my city colleagues, I’m actually on the cheap side! Yikes.

If I’m able to find a multifamily where the other units can cover my mortgage, I can reduce my living expenses monthly by $1,600 or annually by $19,200. That’s relatively little effort, for massive savings and accounts for a big chunk of my annual expenses.

tax savings

Taxes Are Likely Your Largest Annual Expense

I’m a CPA, so naturally I have to talk about taxes. Taxes are likely the largest expenditures any one of you incurs each year, aside from housing. Wealthy individuals understand this concept and constantly consult with tax advisors to minimize their tax burden. They view professional fees as an investment rather than an expense, and one that will provide returns in the form of drastically reduce their tax bills.

Ben Leybovich wrote a great article several weeks ago about personal “burn rates.” The burn rate is the rate at which an enterprise spends money. You’re not treating your personal finances like a business? Shame on you! Track your monthly income and expenses just like any business would and see how much you are cash flowing. If you aren’t doing that yet, it will be eye opening.

Anyway, taxes significantly add to the burn rate, and those people who break out of the low or middle classes and into prosperity truly understand how to minimize their tax liability. Those people take deliberate steps to reduce their taxable income, and do you know what step one is? Getting rid of the W-2 income. An example below illustrates my point.

Higher Earner vs. Smart Investor/Business Owner

I’m going to illustrate the differences between those who understand that a high paying job is not the best long-term wealth building route to take and those that do not.

Sarah’s Story

Sarah has done quite well. She’s in finance and only four years out of college. Her salary is an impressive $110,000, she lives in a city, and she is proud of how successful she is. She contributes 6% to her employer 401(k) and has a solid health plan. Her friends envy her lifestyle and success, yet they don’t see the whole picture. The problem is Sarah’s burn rate.

To be close to her job, Sarah rents an apartment in the city that costs $2,100 per month with utilities coming in at around $200 per month. Sarah spends annually $27,600, none of which is tax deductible. Additionally, because Sarah rents, she neither has property taxes nor mortgage interest.

Let’s look at the taxes: Sarah makes $110,000 and contributes $6,600 to her 401(k), which will reduce earned income to $103,400. Sarah has no other income sources and is phased out of deductions, so $103,400 is also her AGI. Sarah cannot itemize, mainly due to the fact she rents, so her standard deduction of $6,300 and personal exemption of $4,000 further reduces her AGI to $93,100, which is her taxable income. Her tax liability based on this income is $19,251.

Additionally, a commonly overlooked fact is that Sarah will also pay payroll taxes of 7.65% on her $110,000 salary, or $8,415. This brings her total tax liability to $27,666. Between taxes and rent/utilities alone, Sarah’s annual expenses are 50.2% or her annual salary, or $55,266. That’s a very high burn rate, and we haven’t even factored in basic living expenses, such as food!

Sarah is therefore left with $54,734, including her 401(k) contribution, to spend how she chooses.

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Tom’s Story

Now let’s switch gears and look at Tom. Tom is also four years out of college and spent the first three working for corporate America. Tom works in the same city as Sarah. Tom found BiggerPockets early on in his career and decided that the key to wealth building and lifestyle design is that it’s not about how much you make; it’s about how much you keep.

So Tom purchased a property using his corporate W-2 to obtain financing. Because he decided to look around the city rather than in the city, Tom found a reasonably affordable 4-unit for $350,000 which he decided to owner-occupy. Tom put 3.5% down, and his monthly payment comes out to be about $2,300, which includes that pesky mortgage insurance.

Luckily for Tom, with the knowledge he gained from his time spent on BiggerPockets, he figured that each of the three units will rent for $900, and he was right. So Tom actually earns $400 per month for living in his property. He also has utilities, though his tenants pay for their share, so Tom only pays $200 per month, leaving him with a net $200 cash flow per month.

With the massive decrease in housing expenses, Tom was able to quit his corporate job and open up his dream business. He provides services to clients, and during the year, he nets $55,000. Great for the first year in business; poor compared to Sarah—right?

Not really. Tom understands taxes are painful and has sought out a good CPA. The CPA set him up with an S-Corporation, and Tom is able to pay himself a salary of $22,000. The remaining $33,000 is taken as a shareholder distribution, which is not subject to payroll tax. Tom, like Sarah, also contributes 6% of his salary to his 401(k)—although his CPA advised him he can contribute significantly more with employer contributions.

Let’s look at the taxes: Tom’s salary is $22,000, and he contributes $1,320 to his 401(k). His real estate income and expenses net out to $0 for tax purposes. He also has $33,000 of taxable income from his S-Corporation taken as a distribution. Tom’s AGI will be $53,680. Tom is able to itemize as he pays mortgage insurance and property taxes, which pushes him over the standard deduction threshold. His itemized deductions come out to $9,180, and his personal exemption is $4,000, reducing his AGI to $40,500, which is also his taxable income. His tax liability based on this income is $4,969.

Additionally, Tom must pay both the employer and employee halves of payroll taxes of 15.3% on his $22,000 salary, or $3,366. This brings his total tax liability to $8,335.

Remember, Tom’s net income for his multifamily property was $0 for tax purposes, but Tom actually cash flows $200 per month, which is essentially tax-free. How does this happen? Depreciation!

Taking into account Tom’s taxes and living expenses (or lack thereof), Tom’s annual expenses based on these facts alone is 26.9% or $5,935 ($8,335 – $2,400 of tax free rental income). This leaves Tom with $49,065 to spend as he chooses.

Please note that this example is purposefully not using like-kind variables. Life is full of variances and the two points I’m attempting to drive home are: (1) it’s not about how much you make and (2) thinking strategically about your finances can drastically change your entire life.

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Who Has it Better?

Honestly, I don’t know. I don’t know how much Sarah works compared to Tom. I don’t know how much they enjoy their particular situations. But if I had to guess, I’d say Tom is better off for several reasons.

First, many of Tom’s everyday expenses can now be strategically written off as legitimate business expenses. This will provide Tom with savings that are unachievable to a W-2 employee such as Sarah.

Additionally, Tom runs his own business and is his own boss. There are pros and cons to this of course, but based this article that claims 52% of employees are unhappy at work, I think the odds of Tom being happier is higher than that of Sarah’s. As a business owner, Tom’s earnings potential are unlimited and can be tied directly to his efforts and implementation of business systems. Compare that to a W-2 employee whose earnings are tied to annual performance reviews and how well they can negotiate with HR.

Tom has also mitigated his risk of income loss by having multiple income streams. If Tom doesn’t get paid, he won’t be facing an eviction or even a foreclosure since his tenants are paying his mortgage. Sarah on the other hand will be in trouble if she is fired.

From a tax standpoint, you can clearly see who is better off. Tom can strategically implement tax plans to reduce his business income and payroll taxes—strategies which are unavailable to those who hold W-2 jobs.

The moral of the story here is clear: Business owners and real estate investors have a massive advantage over everyone else. This can be further substantiated by examining how the world’s wealthiest people earned their wealth (hint: it wasn’t from that W-2 job).

What Should You Do?

Evaluate where you are now and where you want to be.

Start with looking at your personal income statement and statement of net worth. If you’re not tracking these, then you should start today. Heck, shoot me an email and I’ll send you my templates.

Once you are tracking your expenses, you’ll notice that you spend more money in a few key areas over all others. For most of us, the top two will be living expenses and taxes. Your job is to figure out a strategy parallel to your goals to reduce your top expenses.

I understand that you may not be in a financial position to take down a multifamily property. My challenge to you would be to do whatever it takes to get to such a position. If it’s simply impossible, consider picking up a single family home and renting out the rooms—same idea, but just sharing the same space.

I also understand that many of you have families and owner occupying a multifamily is not an option. Can you make the bonus room above the garage rentable? Do you have a detached guest house on your property that you don’t need? Can you downsize and use the excess cash to pick up a couple of rental properties? Get creative here.

I hate paying taxes, which is ironically why I love the specialization so much. Anything I can do to legally reduce my tax liability I want to take full advantage of. It has become clear to me through helping clients and extensive readings/research that business owners and real estate investors are not held hostage to the tax code, rather the tax code is their friend.

So my next challenge to you is: figure out how to get out of the corporate world and into business for yourself. This can be a real business or just managing your rentals. Of course, this is easier said than done.

To mitigate the financial risk, build a side business while you maintain full-time employment. You don’t have to quit your job tomorrow; you can be smart and strategic about the timing of jumping into a side business full-time. If that means waiting 3, 5, even 10 years, that’s okay.

Everyone should try to generate side income. You have unique skills that others don’t. Figure out a way to monetize them. From purely a tax standpoint, working for someone else is simply too costly. You may love your job, which is great. But that song Jennifer Lopez wrote: “Love Don’t Cost a Thing” is a huge lie—at least that’s what my parents tell me.

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