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Building Wealth Using Other People’s Money

By JLP | October 18, 2006

One of the easiest ways to build wealth is to do it using other people’s money. Here’s five ways to do just that:

1. Set up an emergency fund with at least 3 – 6 months of living expenses. If you have an emergency fund of at least $10,000, you can increase your deductibles on your car and homeowners’ insurance, potentially saving you $1,000 per year (not to mention the interest you can receive on the emergency fund itself). You can read more about this here.

2. Take advantage of the employer match in your 401(k). Most employers that offer a match, offer a 3% match. This usually means that you must contribute at least 6% of your salary in order to get the match. So, this isn’t a “free” match but it is free money. The numbers are staggering over a career. Take a look at the calculation I made using my How Much Can You Save in a Lifetime? calculator:

401(k) Company Match

Based on my fairly conservative numbers, a company match could mean an additional $341,538 over a 40-year career. If you can manage a 10% rate of return over your lifetime, that number could be $565,047.

Of course not all companies match, so this is not available to everyone. However, remember that your contributions to a 401(k) come off the top of your income, which brings us to the third way to build wealth using other people’s money.

3. Your contributions to your 401(k) represent a dollar-for-dollar reduction in your income, which reduces your taxes. How much? It depends on your personal situation, but using the numbers from the example above, we see that it does help some. Take a look at the graphic I produced using Excel:

The Real Cost of Your 401(k) Contributions

So, for this person, their $3,500 contribution only cost them $3,000, for a savings of $500. Take that tax savings and grow it over a lifetime and we are talking about significant money. UPDATE – As Trent pointed out in the first comment, withdrawals from the retirement account at retirement will be taxable.

4. Take advantage of Section 125 plans (cafeteria plans), which allow you to pay for things like healthcare deductibles and daycare with pre-tax money. Using the same hypothetical example, this person could save an addition $100 if they put allotted $1,000 to their Section 125 plan.

5. Buy a house. Although it would be tough for someone making $35,000 per year to buy a house, it should be something they should be saving for. I’m a firm believer that there is good debt and bad debt. Good debt is debt that allows you to purchase an asset. Bad debt is consumer debt like credit cards and auto loans. Buying a house with a mortgage is utilizing good debt. When mortage interest rates are low (like they are now), buying a house can actually be a good investment as long as you aren’t paying too much and can comfortably afford the payments. And, if you can itemize your deductions, you can actually get a tax break on the interest you pay on your mortgage.

In order to itemize your deductions, your deductions need to add up to more than $10,300 (for 2006). Anything less than that and it is more advantageous to take the standard deduction of $10,300. However, keep in mind that itemized deductions can include property taxes paid, state income tax or possibly sales taxes, medical expenses over 7.5% of your adjusted gross income, charitable contributions, and other items. You can find out more by looking at Schedule A (PDF).

Hopefully I did a good job showing how a person can build wealth by utilizing other people’s money. Did I miss anything? Probably. So, feel free to leave a comment.

Topics: Basics, Financial Math Basics, Financial Planning | 20 Comments »


20 Responses to “Building Wealth Using Other People’s Money”

  1. Trent Says:
    October 18th, 2006 at 1:48 pm

    Great post. It should be pointed out, though, that 401(k) contributions are eventually taxable when you withdraw them, but that’s for your “retirement home” self to think about.

  2. sam Says:
    October 18th, 2006 at 2:27 pm

    Here is another idea. Switch to a high-deductible health plan. open an HSA account, and fund it to the max. Let the money accumulate and pay health care costs out of pocket if possible. HSAs have similar tax advantages to 401k and IRA accounts. Good for folks like myself who have maxed out their 401k contributions but would like to save more.

  3. dan Says:
    October 18th, 2006 at 2:39 pm

    Where the f do you get 10% return (average) over the lifetime of your investment

  4. Daniel Abrams Says:
    October 18th, 2006 at 2:52 pm

    This calculator seems to be in error:

    http://allthingsfinancialblog.com/Calculators/RetirementSavings/RetirementSavings.htm

    When I enter (for example) $1,000 over a 40 year period (age 20 to 60), with a 10% return, the pre inflation number yields 442k, whereas $1000 compounded continuously at 10% over a 40 year period should be $45259.

  5. JLP Says:
    October 18th, 2006 at 3:01 pm

    Daniel,

    Actually, the calculator works. However, it is assuming that the 1,000 is invested yearly over the 40 years.

  6. Kimber Says:
    October 18th, 2006 at 4:34 pm

    So many employees miss out on their employee match (stock purchase plans, anyone?). Thank you so much for pointing out how beneficial they are!

  7. Jonathan Says:
    October 18th, 2006 at 5:10 pm

    Dan, it is not very difficult to earn 10% with investments. The Vanguard 500 has averaged 12% since 1976, for example.

  8. Daniel Abrams Says:
    October 18th, 2006 at 5:30 pm

    I agree that 10% is a reasonable return, and I agree with the lesson behind the chart. However, there is an error in the method used to generated the actual numbers. There is a mathematical mistake in the algorithm used to generate the chart.

  9. Daniel Abrams Says:
    October 18th, 2006 at 5:32 pm

    Ah, invested yearly, I see your point, and take back the comment.

  10. Jonathan Says:
    October 18th, 2006 at 6:03 pm

    I was responding to Dan in post #3. Not to you, Daniel Abrams.

    Just want to clear up any confusion if there is any. :)

  11. prlinkbiz Says:
    October 18th, 2006 at 7:19 pm

    JLP- great to see real estate leverage included! That’s a powerful one!

  12. Walt Says:
    October 18th, 2006 at 10:34 pm

    Does anyone think that contributing to a 401k might not be the best option now? Considering tax rates are at close to all time low, and eventually SS and medicare will implode ergo most likely raising taxes higher later in our lives?

  13. Dus10 Says:
    October 18th, 2006 at 11:25 pm

    Walt, tax diversity is your friend… Roth it up. I have a Roth IRA and a Roth 401(k). That means no taxes on withdrawals when I retire. Employer match is in a traditional setup where it is taxed at withdrawal.

    However, we never know what will happen… who is to say that Roths won’t become taxed, too.

    I really don’t think we will see FICA go up… the people just won’t have it. However, if we get a bunch of bed-wetters in Washington, you never know.

  14. JLP Says:
    October 18th, 2006 at 11:34 pm

    Thanks everyone for your comments. I have been gone all evening.

    Walt,

    I think the 401(k) is a good choice, especially if you get a company match.

    The Roth IRA is also a good deal. For a young person, it may be the best solution since they have a long time until retirement.

  15. Foobarista Says:
    October 19th, 2006 at 4:18 am

    As for the efund/high deductible strategy, we’re big fans. We basically carry high liability and high deductible insurance for wealth preservation purposes.

    In general, you have two strategies with insurance: cashflow preservation or wealth preservation. Cashflow preservation, ie low deductible insurance with lots of bells and whistles, is quite expensive. Wealth preservation, ie high liability and expense capping, is typically much cheaper, but you need a bigger efund to handle the occasional knock to your cashflow.

  16. Lazy Man and Money Says:
    October 19th, 2006 at 1:28 pm

    There’s a nice article and 401k calculator at SmartMoney.com.

    Sadly, I can’t follow a lot of this advice since I moved to California. My company doesn’t offer a 401k plan. The press is talking a lot about NOT buying a home in this market – average house in my town is probably around $1M, while my rent is under $2000 for a two-bedroom.

    As for the emegency fund, I preferred to use a HELOC when I owned my home in Boston. That frees up my 10K to earn that 10-12% in Vanguard 500 instead of the 4-5% in ING. If I do have a real emergency, I’ll be paying, but I think there will be more time with no emergency than time with emergency and I’d want my money working at it’s maximum for the maximum amount of time. Also, it’s not like the Vanguard 500 is going to drop to 0 or I can’t get my money out of it.

  17. fivecentnickel.com Says:
    October 22nd, 2006 at 9:30 pm

    Weekly Roundup – 10/20/06

    Here’s a quick look at posts that caught my eye over the past week (better late than never)…

    JLP has a nice post on building wealth with other people’s money.
    Jim gives us the skinny on paying estimated taxes on a quarterly basis.
    F…

  18. Posts of Note for 10-29-2006 at the Money & Investing Dogberry Patch Says:
    October 29th, 2006 at 7:52 pm

    […] Building Wealth Using Other People‚Äôs Money @ AllFinancialMatters JLP points out that once you have at least $10,000 in your emergency fund you can increase your auto and homeowner deductibles. He does not say how high to raise them, but $1000 would not be a bad place to start. The other recommendations I do not have a (tags: finance, investing, money, retirement, taxes) […]

  19. AllFinancialMatters » Blog Archive » Another Way to Build Wealth Says:
    January 21st, 2007 at 3:04 pm

    […] Building Wealth Using Other People’s Money […]

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    July 5th, 2009 at 10:36 pm

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