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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:
Match.GIF)
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:
RealCost.GIF)
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 |
