[Editor's Note: The following post originally published as one of my regular columns for Forbes and gives 5 ways to rapidly turn a high-income into wealth.]
Income is Not Wealth
To the average American, the title of this post sounds silly. She may wonder, “Isn't someone with a high income already wealthy?” This person has not yet learned a critical distinction and an important lesson in building wealth–income is not wealth. The most common measure of wealth is net worth–everything you own minus everything you owe. It is entirely possible to have a very high income and have a negative net worth. Likewise, it is entirely possible to have a very low income and yet possess vast sums of wealth. Income is not wealth despite how our tax code, innumerable newspaper articles, and the majority of people talk about it.
Even someone financially astute enough to recognize the difference between income and wealth may express surprise that an article like this one needs to be written; “Surely it must be easier to build wealth on a high income than on a low one, no?” The answer to that, of course, is yes, all else being equal. The problem is that all else is never equal.
As discussed in my very first column here at Forbes, high-income professionals typically face a number of barriers to building wealth. These include a late start (their 20s and even part of their 30s are often spent in education and training), a high student loan burden, a progressive tax structure, high liability, high stress/burnout levels, and a general lack of financial literacy/business training.
While most high-income professionals should become wealthy eventually, the above factors prevent a surprising percentage of them from ever building significant wealth. (Remaining factors such as divorce and lack of financial discipline are common in all income brackets.) Net worth surveys of physicians in their 60s, generally at the end of a 30+ year career, show that one-quarter of them have a net worth of less than $1 Million, and 12% have a net worth of less than $500,000!
The good news is that this is a relatively simple problem to fix. Applying a few rules of thumb to a simple spending plan can ensure that anyone with a stable, high income can build wealth rapidly.
5 Rules to Becoming Wealthy On a High Income
# 1 Save 20% Of Gross Income For Retirement
It really doesn't matter what you do with the other 80%. You can spend it on a fancy house, a fancy car, fancy clothes, expensive vacations, private school for the kids, charitable contributions or heli-skiing. But that 20% is sacred. It must be dedicated toward saving for retirement.
Combining the 20% rule with a high income, a reasonable investing plan, and a typical career will result in retiring as a multi-millionaire. It really is that simple. Remember that 20% is from your gross income, so if you take the taxes out first it is really going to be 25-30%.
Also remember that any savings for other financial goals such as college, a house down payment, or a new car is going to be above and beyond that. Extra payments toward debt are also above and beyond the 20% for retirement. While it would be nice to be able to spend that 20% on whatever you like, the good news is that even 80% of a high income provides a very nice lifestyle compared to the average American.
# 2 Pay Off Student Loans Within 5 Years of Completing Training
Lenders will permit you to put your student loans on a 20 or even a 30-year payment plan. This is generally a terrible idea for someone who actually wants to build wealth. The main reason is the income that is going toward servicing loans cannot be used to build wealth.
Want to become wealthy? Drive your cars a long time. This one is over 100 years old.
Perhaps more importantly, the financial discipline developed while paying off the student loans quickly can be redeployed toward building wealth. Most borrowers who pay off loans quickly also describe an emotional or psychologic relief at doing so, like a great weight has been lifted from their shoulders.
Paying off a sizable student loan burden within 5 years while also saving 20% for retirement will require a period of relatively frugal living after training, typically lasting 2-5 years. Completing this “Live Like A Resident” period will require delaying gratification and fighting off a sense of entitlement.
It also helps if you can limit the amount of student loan debt in the first place. A ratio of loans to income of 1:1 is reasonable and represents a good investment in your future earnings ability. The higher that ratio gets, the longer and more drastic the frugal living period will need to be.
# 3 Don't Become House Poor
Americans generally overestimate the amount of happiness they will get from owning a large, expensive house. Combining this with widely available “affordability calculators” available on the internet gets many doctors and others into financial trouble.
It helps if you realize that the ratios commonly used by lenders are for their benefit, not yours. They represent the maximum percentage of your income at which you are likely to be able to make the payments, not the optimal ratio for you to build wealth. A lender may be comfortable with payments that are as much as 43% of your gross income, but you shouldn't be. Since 20% of your income is going toward retirement savings and perhaps as much as 30% is going toward taxes, a house costing 43% of your incomes leaves only 7% for everything else.
A much better rule of thumb is that your housing (rent, mortgage, property taxes, insurance, and utilities) should cost no more than 20% of your gross income. An easier one to use that provides similar outcomes is to keep your mortgage to less than twice your gross income.
# 4 If You Can't Pay Cash, You Can't Afford It
The easiest way to know if you can afford to buy something, at least outside of paying for medical school or your primary house, is to see if you can pay cash for it. Borrowing money to pay for cars, boats, vacations, appliances, furniture, or anything else is a good way to ensure that your income services payments instead of building wealth.
This concept seems amazingly simple, but there is almost always a less expensive version of whatever it is you want to buy. If you don't have the money for the more expensive version, don't buy it. This key principle of frugality is perhaps best exemplified by the classic saying from the Depression era–“Use it up, wear it out, make it do, or do without.”
It doesn't matter where your friends, family and neighbors vacation, what they drive, or where they send their kids to school. What you can afford and what they can afford are two very different things and resisting the urge to “keep up with the Joneses” is critical to building wealth. Wealth is actually the cumulative sum of all the things you didn't buy but could have.
# 5 Choose A College You Can Afford
The same principle of frugality applies to college selection. There is a dramatic difference in cost from one college to the next, even when the quality of education is very similar. If a family cannot afford a given college between their savings, their cash flow, scholarships, and the student's work during summers and the school year, they cannot afford that institution and should select one that costs less.
There is little reason to borrow for undergraduate education. This recommendation breaks down when discussing professional schools like medicine, dentistry, and law, but presumably, these degrees will eventually generate sufficient income to justify some debt (see # 2 above.)
It should be relatively easy for a high-income professional to build wealth, but it isn't automatic. These five rules of thumb will help any physician, dentist or attorney rapidly turn their high income into wealth.
What do you think? Why do you think those with a high income have such a hard time building wealth? Do you have additional rules of thumb you would include? Comment below!
Wealth building should be automatic, but it isn’t for many high-income earning physicians. Most simply don’t know any better. With no financial education in college, medical school, and residency – they are left to their own devices to swim in shark infested waters. All that delayed gratification then causes bad decision after bad decision.
I wish the narrative wasn’t common, but it is.
Completely agree on your five points. Buying with cash is one of the biggest! Changing the mindset of monthly cash flow and “affording monthly payments” to the big picture of wealth is really the biggest game changer. Once people stop thinking about “affordability” as a monthly budget item (i.e. a car payment, mortgage, etc) and think about assets and debts and eventual goals… this really impacts the way we view money. The more we buy things with cash, the more we flex that muscle, and the easier it becomes.
Thanks for a good reminder!
TPP
“Wealth is actually the cumulative sum of all the things you didn’t buy but could have.” I love that line!! Definitely going to keep going back to it every time I think about buying a Tesla.
Get that Tesla lol. If you can buy it in cash and live the rest of your life responsibly, 1 car purchase that costs 10K -15k more than something else you would have bought is not going to bankrupt you.
I agree that it’s really the house that gets most of us into trouble (myself included).
Comparatively a car payment is a relatively brief detriment to wealth building, though it does delay financial independence as well.
The keeping up with the Jones’s phenomenon is quite real. After a few years in Los Angeles, BMW 3 series seem like Honda Civics. You often see Mercedes and Audi SUVs parked outside of crummy studio apartments.
I was talking to a second year dermatology resident yesterday who could end up in either Los Angeles or Connecticut based on his family ties.
I told him to strongly consider staying put in Connecticut, despite the frigid winters.
— TDD
“Income is not wealth”, truer words have never been spoken.
When you walk back how “wealth” is created, you find how “income” doesn’t equal wealth. You can’t become financially wealthy if you don’t, first, save, and invest.
Great post.
High income earners, especially physicians with their delayed start, actually have a lot of things going against them to actually build wealth. The progressive tax system takes out a bigger chunk from your earnings than a low earner. A lot of the tax deductions that others take advantage of quickly get phased out at the higher salaries.
The savings rate is key as defense in this case is far more valuable than offense. I save a dollar, my net worth grows a dollar. A earn a dollar more, my net worth, at best, can only grow $0.63 at the highest income bracket and likely even less if you have state income taxes on top of that.
I will tell you that in my culture (Indian) which stresses education so much, there is bragging done about where your kids go to college. I went to Johns Hopkins which was very prestigious but carried an enormous price tag. I have to debate this thinking as my daughter rapidly approaches college age.
I think it bad to be house poor as well as house rich (if your home is the majority of your net worth, unless you plan on selling it, there is very little positive cash flow that it will generate and really not considered an asset).
I know what you are saying re: the Indian community’s outlook on the price tag of education… I see it all around me. There was a scandal in town (and not a small town either!) when one doc sent his daughter to the local university instead of an Ivy League like all of his kid’s friends- and not because he couldn’t afford to. I do not suffer from the “keeping up w the Jones’es” phenomenon in the least but this is one area I haven’t been able to figure out yet. Fortunately, I still have a decade to decide. Good luck with your decision!!
Wow! Talk about peer pressure.
Do you consider principle payments on a mortgage as part of the “saving” 20% of gross income? How do I factor the mortgage payment in?
20% of gross is for retirement. Everything else is above and beyond that – toys, student loans, extra principal payments to a mortgage, college savings, new cars etc.
Great article. For a 35yo 1099 worker earning 300k who does solo 401k + backdoor roth gets you to the 60k very easily.
1. Is this counted for the 20% rule already assuming you have a 20+ year career ahead of you?
2. If one were wanting to Fire, I am guessing another 20% or 60k-100k in a taxable account yearly would be the minimum.
3. For younger people aiming for FIRE (under 40), is the 25-30x number specific for a taxable investment goal solely since those tax deferred accounts aren’t easily touchable before 59.5, aside from a few exceptions, but the goal should be to attain that number in your taxable on its own given the younger age range and longer period before having access to the IRA ?
Thanks as always.
1. Sure.
2. Depends on when you want to FIRE. The more you save and the less you spend the faster you hit FI and can RE if desired.
3. One of the exceptions is early retirement, so no, I don’t feel like it has to all be in taxable. I would NOT pass up a chance to save in a tax-protected and asset-protected account in order to build a taxable account.
https://www.whitecoatinvestor.com/early-retirees-max-out-retirement-accounts/
For a single 35 yo whose income is likely headed very close to 500k (1099) and should stay for 3-5 years at least with no debt, spending 3k in total monthly expenses (live like a resident) who is already maxing out solo 401k,hsa,backdoor roth and has no employees would having a Cash balance plan be a no brainer vs dumping the rest all in taxable?
I know I am on the younger side but given I have no employees it will cost me 4k first year fees then roughly 2k after and a 5 year analysis i just had done says should net me 450k which i believe if plan is terminated can rollover straight into your IRA. At least 2x that if i got it closer to 10 years. Almost sounds too good and I know how strong you are about maxing out those IRAs.
The only downside is my solo 401k max contribution will drop from 56k to 36k due to rules of having 401k plus cash balance with no employees but its a moot point as the cash balance starts at year 1 at around 70k deductible and increases 5-10k every year after that is deductible.
Thanks as always.
Sure. Seems like a reasonable choice. I don’t know how large your contribution will be; you’ll have to weight that against the fees.
…do you consider HSA acct in the 20% as well, if we are using it as a retirement acct?
Sure, why not?
Dont borrow money for toys.
Another great post, and how accurate. I think a lot of it depends on how you were brought up, and the values instilled by parents and others. Although I grew up solidly middle class, my parents took us on trips to South America, out West to the national parks, skiing every year, and to many Broadway shows since we lived near NY. However they always drove fairly cheap cars, ate out only at diners and cheap Chinese restaurants, and never splurged on other material things etc. I do the same. For the first 10 years or so of my practice, we lived in a house less than 1 x income, drove modest cars paid for with cash, and mostly vacationed at my parents’ (beach, but full-time) house, since a pain to travel with young kids anyway. Saved aggressively including for kids’ colleges.
Now in 50’s, and can spend more on the things like my folks did – amazing trips, shows etc. And the college expenses are saved from years of slowly adding to 529’s. You can do it; just be very careful and save a lot in first part of attending career.
Like most people, you have expanded the middle class to include your family. If you ask people, nobody is poor and nobody is rich–the middle class must go from the 2%ile to the 98%ile.
Clearly a family with multiple kids earning the median household income does not go on multiple trips to South America, much less ski as a hobby and go to Broadway show. A Broadway show is $150. X 4 = $600. Median household income is $60K, perhaps $50K after tax. Broadway tickets are 15% of monthly income. And a ski trip or international travel? Give me a break. These are not things the average household does.
My upbringing was probably above the median household, but there was no way we were doing any of those things (other than skiing at the local ski hill on used gear a few times a year and driving to National Parks in our state.)
Didn’t call myself “middle class;” that was my folks, who earned about 1.5 the average median income of the U.S. through those years. Remember that Bway shows in the 70’s and 80’s were less than $15 a ticket, and travel, especially staying in cheap hotels, more reasonable. They just scrimped in other areas to afford those things.
I was talking about your parents.
But I guess that’s a good point, both skiing and Broadway used to be much cheaper. At any rate, you made my point when you said your parents were 1.5X the median. That’s all I was saying.
Agree with all this except the house. I have lived 99% of my life in California, and have always come out way ahead buying nice homes. This is because of the insane price appreciation here. An argument can probably be made that putting the money in equities would have paid as well or better. But you cannot live in your stock portfolio. And there are distinct advantages to having wealthy neighbors, gated communities, great public schools and very low local crime rates. OTOH sometimes some people assume you are a snob because of your address, but driving a pick up truck helps.
What are the critical percentages when considering post- tax income? Is a 35% savings rate of post tax take home income exclusively for retirement sufficient?
Living in a very high tax city and state and owning a practice that finances things with retained earnings means my take home income and my pretax income have a very tenuous connection and combined income taxes regularly exceed 60% of income.
Sufficient for what? Is it enough to be financially independent within 10 years? Probably not sufficient for that. Is it to be financially independent within 20-25 years? Very likely.
It all depends on your goals and what you spend in retirement.
I agree that it’s really the house that gets most of us into trouble (myself included).
Comparatively a car payment is a relatively brief detriment to wealth building, though it does delay financial independence as well.
The keeping up with the Jones’s phenomenon is quite real. After a few years in Los Angeles, BMW 3 series seem like Honda Civics. You often see Mercedes and Audi SUVs parked outside of crummy studio apartments.
I was talking to a second year dermatology resident yesterday who could end up in either Los Angeles or Connecticut based on his family ties.
I told him to strongly consider staying put in Connecticut, despite the frigid winters.
— TDD
I don’t think the cost of living or tax situation in Connecticut is really much better than California.
You’re right! I thought the income tax situation was better in Connecticut for some reason, but I was mistaken.
One thing it does have going for it is a median home price that is half that of California. (About a quarter million dollars versus half a million dollars.)
But tax-wise it seems you’re absolutely right that it’s not much better than California.
— TDD
Compare the cost of housing (and property taxes) in neighborhoods with decent public schools. Look again at the income taxes in CT and CA, then compare the weather.
There are a lot of locations with lower taxes, lower cost of living, and saner politicians than California. However, I wouldn’t necessarily put NY, NJ, CT, or MA on that list.
I never heard the words “net worth” until I was 58 years old and had a net worth of $450k. For some reason I was always in the present and never thought about retirement. Four years later I have over $2 million with aggressive saving. But I wish I had known about this at age 40 when I started my (late) career. I would be so much further along and have the option to retire. And could have let compound interest work more than brute savings.
Should employer contributions (profit sharing / 401k/match) be included in one’s gross income when making these types of calculations? I lean toward yes but want to see what the general consensus is. As a simple though unrealistic example, if you made 200K and your employer contributed 50K to retirement, I would assume a gross income of 250K with the employer contributing the full 20% to retirement, therefore requiring no further savings from the individual.
I view them as part of your salary as you do. But it’s your life and you get to decide what calculations you want to make.
Personally I think that if one is truly high income – say north of 500k – then 20% savings of gross is pretty low and one should be able to do better. Especially if one is hoping to be FI at a reasonable age and have options to slow down, change paths or retire.
Just because one could save more, doesn’t mean they should save more. But sure, if you want an early retirement, you need to save more than 20%. The earlier the more you have to save.
When you say gross do you mean pre-tax? I’m confused about this term when not applied to companies and operating losses…
Gross was used 12 times in the article. Not sure what you’re referring to. But when I say “save 20% of your gross income for retirement” yes, that’s pre-tax.
Agreed of course but it always strikes me how uncertain things are when I speak with colleagues in the US – costs involving health care, college costs, legal, ongoing expenses related to family, inheritance/legacy, etc. Those things are not nearly the issue here in Canada but they still motivated me to want to save more. The other issue is that if one is making a million a year and only saving 20% that means that one is becoming accustomed to the lifestyle that kind of spending delivers and a 20% savings rate, even with decent investment returns may not be able sustain the same lifestyle in retirement. Probably my inner Boglehead/Scot coming through.
Why not? The ratios work exactly the same. $200K of $1M is the same as $40K of $200K.