The cash-flow quadrant isn’t just about income, it also has to do with taxes. Taxes may sound boring but if you want to save taxes, which puts more money in your pocket, you need to understand something about them.
What is the Cash-Flow Quadrant?
The Cash-Flow Quadrant is relatively well-known today in large part because of Robert Kiyosaki and his book “Rich Dad Poor Dad”. You can find a link to that book in the suggested reading tab on this site. Rich Dad, Poor Dad is a mindset book. The premise of it is that Wealthy people think differently about things, in particular about money, than poor people. To summarize a bit, Poor people tend to think or say “I can’t”. Such as I can’t afford this. I can’t do that. Whereas the rich or wealthy ask “How can I?” How can I purchase this? How can I do that? And then they find the solution.
To give a real-life example from my personal experience, I will use a property I currently own. I have discussed this in previous posts. I have some commercial land in Arkansas that I am flipping. When I first had this land sent to me I understood the great value it had. Lots of potential for high returns. At a minimum to double the purchase price. The problem was that the purchase price was $540,000 and I had to be able to close on it in less than a month. Knowing that I did not have that kind of money available I could have said, “I can’t do that!” “I don’t have that kind of money.” But instead I asked myself, “How can I get this done?”
So I did the smart thing. I got the land under contract and I started contacting people I knew. I used the connections I already had at the time, and some new ones I was making for this purpose (see the previous post on networking). I was able to get other partners to join me who brought all the money needed to do it.
E, S, B, I
With the Cash-FLow Quadrants, there are 4 letters. They signify Employee, Self-Employed, Business Owner, and Investor. The point of what you eventually want to do is move from the left side (E & S) to the right side (B & I). The reason being is that on the left you are trading time for money. As an employee you are giving your time to do a job in exchange for payment for that time. You are helping make someone else in the B quadrant wealthy. If you don’t work, you don’t get paid. You can never get ahead doing just that, even if you get paid a lot of money. As a Self-Employed person, you may be working toward that becoming a B, but in the meantime you are also trading time for money. The only difference is that you are working for yourself. But the same problem is there, if you don’t work, you don’t get paid.
However on the right side, if you own a Business that means you have employees who work for you. You may still have to put in a lot of hours initially but eventually you will be able to step away and let others do all the work for you. You are then buying back your time. As an Investor you get to let your money work for you. You are no longer putting in any time (or very little, some oversight may still be needed) so that you can relax and enjoy your life and have time freedom while you are still earning money. This is the best place to be. This is where those that are in the E, S, and B quadrants should be putting their money so that at some point there is enough income that they have the option to leave that job or step away from the business.
Cash Flow and Taxes
Purely based on income you may be able to do pretty well as an Employee, such as a CEO. But, income doesn’t mean anything if you don’t get to keep it. There is a saying that goes something like, “It doesn’t matter how much you make, what matters is how much you keep!”
Consider this. One guy makes a $500k/year salary. Pretty good, right? And another woman makes $200k/year. Still a decent pay, but may be considered poor by the guy making $500k.
If a person makes $500k per year but is taxed at 60%, then he is only keeping $200k. He works long, stressful hours for this salary. Feels kind of like a ripoff having to pay that much in taxes, right? The woman who makes $200k is all from passive income. She maybe only spends maybe one hour per month talking to property managers and looking over reports. She has worked with her CPA and tax advisor to set her up to pay 0% in taxes. So she keeps 100% of her passive income. Which is better? The guy making $500k gets to brag about his important job and what he gets paid. But he doesn’t really get to enjoy it because he is working 80 hours per week and paying so much in taxes that what is left over barely pays for his mansion and fancy cars. Not counting his primary residence, his net worth is maybe around $500k because of all the large debts he has to maintain his lifestyle.
The woman who makes $200k in passive income lives modestly in a normal house in a typical neighborhood. She drives a nice used car. She travels often and has time to spend with friends and family and volunteers to help several charities. She is not stressed and enjoys life. She has a net worth of several million dollars because of the appreciation of her rental properties. Her wealth will continue to grow as her properties get paid down and go up in value and every year she invests in more opportunities as a passive investor because she no longer wants to take the time to look for and research and manage her own properties.
Which situation would you rather be in? What is most important to you? For me personally, my time is the most valuable. Check out this post regarding the value of time.
TAXES
The saying goes that two things in life are guaranteed. Death and Taxes. As for now, not much we can do about death. But we can do something about taxes. Looking again at the cash-flow quadrant, the left side (E & S) pay a lot more taxes than the right side (B & I). Why is that? Does that seem fair? Most people complain when they hear that the wealthy pay little taxes. Well, it isn’t that they don’t pay taxes, but rather that the government incentivizes them.
Look at it this way. As an employee how much risk are you taking on? Are you providing any benefit to society? Sure, you are helping the business to provide the service or widget it makes. But you, yourself, are not the one making that service or gadget. The Business is doing that. So if the Business gets sued or fails, you are not the one getting sued or failing. If the business fails you will be out of a job. If you quit the business will continue to operate.
Businesses and Investors take on a lot of risk. They usually will be taking on a lot of debt. Most people are risk averse. Meaning they want to avoid risk. If I want to start a business but because there is a chance it will fail, I don’t want to put my life savings into it and quit my job with guaranteed income. However if the Government provides some incentive to help motivate me to take that risk, then I may consider it. The Government may provide some business loans and give me some tax incentives because of the expenses I am making to get this business operating. The Government is sharing in the risk and becoming my financial partner. Why? Why does the Government do this?
The Government wants to create jobs. It is always a political talking point. How many jobs were created or lost. They know that THEY cannot provide jobs. They don’t have time or knowledge to run millions of businesses. So, they provide some tax incentives so that WE will take those risks to create jobs as Business owners, and to provide good, clean housing as Real Estate Investors, or as investors in stocks or other forms of investing to help stimulate the economy. Business owners and Investors create jobs, housing, energy, food, new inventions, new ideas, etc. The Government wants US to do the things they need done. The way they do that is with tax incentives. The Government isn’t “giving” us money, they are in a sense, Investing in us! They are sharing in the profits. They follow my mantra that, it is better to get a part of a great deal than 100% of no deal.
Pay Less Taxes
Robert Kiyosaki said that the purpose of a business is to buy Real Estate. And to use massive amounts of debt to not pay any taxes.
Depending on your income level as a E or S, you may be paying between 40%-60% of your income in taxes. Pretty crazy! Lower income employees are taxed much lower. In some sense when you get a huge tax return I think some people are either paying 0 or maybe even negative tax. I know some years it felt like that for me when I had elected to not pay a lot in taxes but still got a large refund.
If you are on the B and I side you may be paying 20% or possibly 0% in taxes. So ideally, even if you are in the E quadrant, you should be trying to focus as much as you can to move your money to the I quadrant. That way, even as an employee paying higher taxes, you can start receiving some of those incentives which helps reduce your overall tax bill. If you are a Business Owner, obviously put some money back into the business, but also be an Investor as well to also help reduce your taxes and provide additional income and wealth. Over time the investments will grow and your goals and perspectives may change once you realize you have the opportunity to purchase your time freedom and escape the hamster wheel.
Additional Reading
Renowned CPA and Author, Tom Wheelwright explains a lot of this in further and better detail in his books. One of my favorites is Tax Free Wealth, which you can find also on the suggested reading tab. He has another book coming out soon specifically discussing incentives the Government provides to help pay you to start a business. You should definitely get both of these books. I will read and review the incentives book as soon as I can and add it to the book list. You can also follow his podcast. And watch the Bigger Pockets Real Estate podcast episode 569 where he was the guest. You can find the video replay on YouTube.
Even if you do not like or understand taxes, you NEED to know something about it. Your CPA may not know or understand all of these things, especially if your CPA is also not an investor. So it is in your best interest to know something about it to be sure your CPA is giving you the best advice possible and not leaving anything on the table.
Free Yourself!
Gain the knowledge and understanding to begin converting your Active income into Passive income. This will make it so that you pay less taxes and eventually so that you can also have time freedom and freedom of choice. You can decide to quit your job if you want, or take the chance to start a business or change careers to try out something else. The risk is removed because your investments can help support your needs.
If you would like to learn more about how you can become a Passive Investor in Real Estate opportunities, please contact me. I will be happy to discuss how it can help you and the types of opportunities that may be available to you to provide both a great income AND tax benefits. You can also refer to my previous post about investing in RV Campgrounds for a more fun way to invest.