Personal Finance Musing 15: An Interesting Way to Look at the Income Tax

PERSONAL FINANCE MUSING 15

AN INTERESTING WAY TO LOOK AT THE INCOME TAX

We are continuing with our journey through the brilliant book, ”The Millionaire Next Door” written by Thomas J. Stanley and William D. Danko, in 1996. The authors wrote this book after their extensive research on American millionaires spanning many years. The research brought out many surprising conclusions which we, as common middle-class persons, would do well to emulate, if we too wish to become a millionaire in one generation.

My impassioned plea - please keep sharing these posts with your near and dear ones especially young adults, for these are a run up to my book, “Musings of a (financially) illiterate father”, likely to be in your hands next month. The book has been specially written to teach the alchemy of wealth creation and retention to our children. They deserve to learn it.

1.       Pay Yourself First.        I have already covered this concept in detail in my post on 01 Apr. I will request you to go through it again, the link is provided below. It remains the fundamental concept for long-term wealth generation.   American Millionaires (more than half) invest first and then spend. The minimum they invest is 15% of their annual realized income. What does the “pay yourself first” strategy do? It creates an artificial economic environment of scarcity for the household, which in the long term, results in their being Millionaires. Obviously, the money that doesn’t come into your hands is not missed by you.

https://andysfinancial.blogspot.com/2018/04/musing-4-pay-yourself-first.html

2.       The Power/Tyranny of Compound Interest.   

           

I have covered this concept too in the post on 31 Mar, the link is given below. The authors give a wonderful real-life example of the same. The parents of one of the ladies, who was interviewed by the authors, were chain smokers consuming three packs of cigarettes a day which translated to 1,095 packs a year. Over their lifetime of 46 years, they smoked more than 50,000 packs which cost them approximately $33,000- more than the purchase price of their home.

The tyranny of compounding starts here. If they had invested this cigarette money in an index mutual fund, it would have been worth nearly $1, 00,000, a humongous amount indeed.  But what if they had purchased shares of the tobacco company (Philip Morris- which they smoked) from their cigarette money and then reinvested all their dividends received during all of 46 years? Their tobacco portfolio would have been worth $2 million.

This is a classic case of understanding the tyranny/power of compounding, which any smart investor should endeavor to work in his favor. The seemingly small expenses- our latte factor, can grow to serious amounts if invested regularly.

https://andysfinancial.blogspot.com/2018/03/musing-3-eighth-wonder-of-world.html

3.       Income Tax         - an interesting take

Tax and death are the only two certainties in life- so goes the axiom. The authors give a very interesting take on the income tax. We tend to think income tax in relation to the realized income, but what if we calculate income tax in relation to our net worth? We will suddenly find our true financial status. We have already seen what the net worth is, so let’s see this concept in action.

We take two persons- let’s call them Mr. PAW and Mr. UAW (remember the definitions from the previous post? The link is provided below), both 40 years of age with an annual income of Rs 20 lac. Since their annual income is same, both pay income tax @30% of income i.e. approximately Rs 6 lac. The net worth of Mr. AAW is Rs 1.6 crore while of Mr. UAW is Rs 40 lac. What is the percentage of tax they pay in relation to their net worth? Mr. UAW pays nearly 15% of his net worth as tax while Mr. PAW pays barely 4%.

https://andysfinancial.blogspot.com/2018/06/personal-finance-musing-14-road-to.html

See how stark the difference is? This has occurred due to power/tyranny of compounding over time- both have been earning for last 15 years. While Mr. PAW has been frugal (hence now wealthy) Mr. UAW has been a spendthrift (hence now fiscally poor).

“If your goal is to become financially independent, your plan should be to sacrifice high consumption today for financial independence tomorrow.”

4.       Significant Purchases

 The authors provide some practical pointers towards purchasing of major assets like house and car. So far as the house is concerned, the total mortgage of the house (if you are not buying it on hard cash- the ideal way) should not be more than twice your household's total income. Taking our example forward, a person with Rs 20 lac annual income should not go for more than Rs 40 lac mortgage-a lovely rule of thumb indeed.

          The UAWs have an interesting way of purchasing a car. They first decide on the type and model of the car, which invariably is the latest and the most fancy, and then go for a hard bargain with the dealer(s). Of course, they manage to get some freebies on the car and thus pat themselves on the back for a wonderful deal. What they fail to realize is that they could never afford that particular car, to begin with. A new car loses nearly 25% of its value the moment it is taken out of the showroom. An AAW/PAW, on the other hand, goes for 2-3 years old used car unless he can buy the car cash down- for which he saves methodically. He drives this car till he could i.e. for next 10 year or so and then repeats the above process.

          We can ourselves decide what is the price of the pride of owning a swanky new car vis-à-vis one’s eventual net worth. It is difficult to live in a Mercedes or BMW after retirement, no? And just as an aside, Mr. Azim Premji, chairman of Wipro, always buys a 2-3-year-old car. Incidentally, he also travels by the economy class when flying. You now know the secret of his being a billionaire?

5.       The Legacy Journey

          As per the research of the authors, UAWs tend to produce children who will eventually turn out to be UAW themselves. This is not surprising since children imbibe the values which they see in their house while growing up. Children of UAW see ostentatious lifestyles, spending without planning, and consumption chasing behavior of their parents. Little wonder that their DNA is accordingly shaped.

          The children of UAW try to emulate the lifestyles of their parents which came about after many decades of earning. Once they start earning they want to fast forward to their parent's lifestyle while earning one-tenth of their income. Aren't they doomed for UAWship (sorry for non-standard English) as their aspirations and lifestyle will not be supported by their current income?

6.       Investing Styles. 

The final and extremely important point from the research pertains to the investing style of UAWs/AAWs. Most PAWs/AAWs are passive investors meaning that they don’t dabble in active stock picking. Even if they buy a stock, they tend to hold it for a really long time. UAWs, on the other hand, were found to be active stock pickers, buying and selling frequently, incurring costs in the bargain. Also, this behavior invariably ensured that they bought a stock well after it was selling low and tended to sell it well after its peak price.

UAW also tended to rely on their financial advisors blindly including "cold callers"- they tended to buy "stocks of the week". AAWs/PAWs tended to listen to the financial advisors but eventually made their own investment decision, based on their research- since they had built up their "financial IQ" over a period of time.

We have covered a whole lot of issues while going through this wonderful book, uncovering real gems of investing which are from the real lives of American millionaires. It is said that success as also successful people always leave clues. We will do well to emulate the lessons that have been covered in the last three posts- albeit duly tempered with our “financial IQ”.

We are now barely three weeks away from publishing date of my book, “Musings of a (financially) illiterate father” and hence the time is right for me to write about my publishing experience. The wannabe writers amongst you might be interested. So, next week, on 24 Jun, we will embark on a new and exciting journey into the world of publishing. Till then, please enjoy your Sunday, you have earned it.