Why Realized Income is Bad for Building Wealth

Do you like having income?

Let’s face it – we all like income, and more of it is always better.

After all, income is what helps us grow our wealth overtime. This is why we’re often fixated on growing our income. Right…?

Nope

On the contrary, higher income results in diminishing marginal benefit. The sole reason for this is the associated tax liability. The more you earn or realize in income, the more you pay in taxes not just in terms of dollars but in terms of the percentage of that income subject to taxes. In certain states in the United States, an income of $1,000,000 may be subject to over $500,000 (or 50%) in taxes. This is bad for wealth building.

Optimizing wealth building requires that you treat every dollar as an employee, and fully deploy that “workforce” to work for you. The problem with realized income is that in contrast to unrealized income, it is subject to taxes and thus it reduces your net proceeds (take-home pay) and as a result, you now have less available dollars to work for you. This is one of the reasons why the wealthiest folks tend to find ways to reduce tax liability – they grow their unrealized income (such as holding onto invested stocks or real estate that have gained value instead of selling them) and minimize their realized income (which would otherwise be subject to taxes).

What Can I Do?

Much like the wealthy, what are some things you can do to reduce your realized income while maximizing your unrealized income/net worth? Here are just a few ideas, especially if you are employed.

1. Take advantage of a 401K or equivalent plan if your employer offers it. This will set aside funds in a tax-deferred account for you, so you don’t pay taxes on them now and can let them compound until you are ready to withdraw them.
2. Take advantage of an HSA (Health Savings Account) or equivalent plan if your employer offers it. This will set aside funds for health related expenses based on your election, and those funds will be contributed to with pre-tax dollars, and still not be subject to taxes while expended.
3. Hold your investments for the long-haul. Do not sell stocks or real estate investments that have substantial capital gains from growing in value – especially not short term gains which are subject to higher taxation rates.
4. Minimize Dividend Income. If you hold stocks that pay out dividends, they are usually subject to income taxes even though you still hold the stock itself, and even if you opt to reinvest the dividends. This is because you are being paid distributions. It may be more favorable to hold stocks that grow in value but pay little to no dividends instead.

All of these are some powerful strategies even the average American can utilize to reduce realized income. You may be reducing your take-home checks by doing so, but in the grand scheme of things your net worth is poised to grow much faster as a result.

Remember, this is something most wealthy people do. It is not tax evasion, it is tax planning.

Have you realized all the disadvantages of realized income now?