Being ‘Rich’ vs. ‘Wealthy’

We often hear the terms rich and wealthy thrown around interchangeably, but they have different connotations. Someone who is rich tends to have plenty cash (this is subjective and depends on your background) at the current moment. On the other hand, a wealthy person tends to possess assets that generate money passively.

It is possible to be rich, but not wealthy. These are individuals who make above average incomes, but tend to immediately spend their money. There’s nothing wrong with this, but it generally makes life a little more challenging down the road. Spending your money immediately vs. being disciplined by saving and investing it guides people towards challenging financial situations. Having the patience to allocate a portion of your capital towards savings and investments helps generate wealth and increases your net worth. Building wealth is inextricably tied with building your nest egg (definition #2, not #1).

A relevant analog would the be the great Stanford Marshmallow experiment. This simple study examined the effects of delayed gratification. A population of young children had two choices – either receive one marshmallow (or whatever your favorite vice is) now, or wait a short period of time and receive two of them. Being patient and decisive with your money nets larger benefits in the future, particularly thanks to compounding.

Why choose wealth over being rich?

Let’s put this in perspective and look at this simple example with 2 people. We’ll look at their financial nest eggs during their careers and retirement.

  • Person #1 aka Bob:
    • Post-tax income of $100k
    • Annual expenses of $90k
  • Person #2 aka Juan:
    • Post-tax income of $100k
    • Annual expenses of $80k
  • For both:
    • 20 year careers
    • Post-tax income stays constant for simplification
    • 7% return on their nest eggs (average historical, real stock market returns)

Working Years

Years workingBobJuan
1$10,000$20,000
2$20,700$41,400
19$373,790$747,579
20$409,955$819,910

Note that this is a simplified example, but it conveys the point. Bob and Juan have identical career paths and income (it’s quite amazing really…). The main difference is that Bob spends $10k/year more for the 20 years of their careers.

Bob and Juan are both considered rich in most parts of the US, but after 20 years Juan is wealthier as his nest egg is about 2x. These two don’t plan on working forever, and after they hit the 20 year mark in their careers, they want to look forward to greener pastures. Let’s examine what happens in the next phase of their lives.

Retirement Years

  • Person #1 aka Bob:
    • 3.5% return on nest egg ($409,955)
    • Annual expenses of $45k
  • Person #2 aka Juan:
    • 3.5% return on nest egg ($819,910)
    • Annual expenses of $40k
Years in RetirementBobJuan
1$409,955$819,910
2$379,303$808,607
12$7,132$671,364
13-$37,618 (out of money)$654,862
36$66,283
37$28,603
38-$10,396 (out of money)

During retirement, let’s say they each spend about half of their current annual expenses during this period – so $45k for Bob, $40k for Juan. Let’s assume they earn 3-4% on their nest egg during retirement and shift towards a risk averse portfolio consisting of fixed-income assets.

Here are the main takeaways:

  1. The 3.5% rate of return implies Bob gets a retirement income of ~$14k while Juan has an income of ~$28k during their first year of retirement. This number decreases as money is withdrawn from the nest egg, but Juan clearly benefits from his higher savings rate during his working years.
  2. Bob runs out of money in 13 years! Assuming both he and Juan retire at 65, Bob will be out of money by 78. Juan on the other hand will run dry after 38 years of retirement, or when he hits 103. Juan with his higher savings rate yields about 25 extra years of retirement without financial worry.

Even with the simplifications in this analysis, there’s no doubt that the effects of being able to grow your nest egg, and wealth, are hard to argue against. Being able to forego luxuries in the near time will improve the odds of you living a financially secure future. The other important realization is that even with a lower income, if you can maintain a healthy savings rate, you can become wealthy.

Remember – two marshmallows are always better than one.

IRA

Oxford Dictionary

IRA [noun] — Irish Republican Army or Individual Retirement Account (your pick).

ELI5

There are many ways to prepare for retirement and a common way to do so is to create an IRA, or individual retirement account. There are a number of different types of IRA’s, but typically individuals will open up either a Traditional IRA or a Roth IRA. The benefit of putting money into an IRA is that an individual has earmarked this money for the future, and it is not meant to be touched until they leave the workforce (of course there are a few, convenient, exceptions).

The terminology can be confusing, but really it comes down to a handful of concepts – taxes and contribution limits. Primarily — when the money is deposited into the account, whether the money is entered pre- or post-taxation.

For a traditional IRA, income before taxes is deposited to the account, and the individual can declare a tax deduction on that amount of income. When the money is withdrawn from the account, it is taxed as regular income.

For a Roth IRA, income post-taxes is deposited into the account. The benefit of this is that the no taxes are paid when the individual decides to withdraw the money giving some extra financial flexibility during retirement.

 

Detailed Definition

As mentioned above, some key concepts that need to be understood are contribution limits, age restrictions, withdrawal penalties, and also a couple less common IRA account types for the average person. We’ll structure the rest of this in an interview form.

Contribution Limits

Roth: Your contribution limits are also dependent on salary. Most importantly, for a Roth IRA, single tax-filers can’t contribute if their AGI earn more than $135K, and married tax-filers can’t contribute if their AGI is more than $190K. These numbers will vary year to year, and are also calculated in a specific way. AGI is adjusted gross income which is total gross income minus some deduction.

Traditional: There are no salary-based restrictions for traditional IRA’s.

As of 2018, an individual’s contribution to traditional and Roth IRA cannot be more than $5,500. This limit increases to $6,500 if the individual is 50 years or older. There are no salary-based restrictions for traditional IRA’s.

Age Limits

Roth: An individual can deposit money, up to the contribution limit, regardless of age any given year.

Traditional: An individual can deposit money, up to the contribution limit, up till they reach 70.5 years of age. This coincides with the age that traditional IRA’s force RMD’s or required minimum distribution (RMD). Refer here to see how it is calculated. Why does this exist? The government doesn’t want you to accumulate money and have it sit pretty in account, it would rather that money go towards the economy.

Penalties

Roth: In most cases, if an individual withdraws prior to the age of 59.5, the withdrawal will be categorized as gross income and an extra 10% tax penalty will be added.

Traditional: Same as Roth.

Exceptions

The exceptions tend to apply to both Roth and Traditional IRAs. Hardship distributions an immediate, financial need is seen. Typical cases include medical costs, disability, tuition, costs related to employee’s residence, funeral costs. These are covered as part of the “Safe Harbor” regulations, please check this for further information. It is also critical that no more than the amount needed to deal with the financial hardship is withdrawn from the account – or penalty fees will accrue. Individuals will be taxed on their hardship distribution as income tax.

There are also another handful of helpful exceptions to IRA early withdrawals. These benefits are specific to IRAs.

  • Healthcare insurance premiums when unemployed pending certain conditions.
  • First-time homebuyers can withdraw up to $10,000 without being penalized pending certain conditions.