We often hear the terms rich and wealthy bandied about. Instead of rich, I prefer to think in terms of wealthy.
So what then constitutes wealthy? There is no doubt that there are many different answers to that question. Some consider investable assets ($500,000, $1,000,000, more?), some think in terms of income ($100,000, $150,000 or $400,000 per year?), while others might consider some combination of investable assets and income, while also mixing in consideration of a home’s value when forming their definition.
The definition I settled on years ago, shaped in part by the Edward Gibbon quote, “I am indeed rich, since my income is superior to my expense, and my expense is equal to my wishes,” is that I am wealthy when my family and I can live our chosen lifestyle on portfolio and passive income; and no longer require earned income.
Types of Income
Labor Income as defined by the IRS is all the taxable income and wages you get from working or from certain disability payments. For most people it is simply the money earned at a job while working for someone else. This is the type of income most are familiar with and the only source of income [unfortunately] for many families. It is generally considered the least desirable type of income for that very reason. You are largely dependent on someone else for your livelihood and have less control. Also referred to as earned income.
Portfolio Income is the interest, dividends, and any other forms of payment received on the investments within your portfolio. Additionally, portfolio income also includes capital gains, realized from trading instruments such as ETFs, stocks, bonds, mutual funds, currencies, commodities, etc. For most people, investing in the stock market is the most common form of building wealth and portfolio income.
Passive Income Also known as residual income, this is income that continues to be generated after the initial effort has been expended. It is the money you get from activities you performed in the past but are no longer required to do for an income (e.g. a pension from a previous job); the creation and selling of intellectual property (e.g. books, patents, or music); or assets that you have purchased (e.g. rental property, assuming the amount collected in rent exceeds the mortgage payment) from which you receive income.
So what is the progression from not being wealthy to wealthy? I’ve given it some thought lately and I believe there are four fairly distinct stages.
In this first stage people become aware of the fact there is a science and art to effectively managing money; they become acutely aware of the importance of personal finance education. During this stage knowledge is attained and the seeds of long-term growth are planted. Early actions likely include dealing with debt – often in the form of student loans for many young people – establishing an emergency fund, and contributing to the first defined contribution plan at work or opening an IRA account. Typical age range: 25 – 35
In the second stage, where I would place myself, people’s financial foundation is firmly established. They are executing a well defined plan for managing their money, their debt is low or non-existent (outside of a mortgage), they have been regularly contributing to retirement plan(s) for a number of years, and they have established multiple streams of income – earning from those during their working years and identified those which will serve them in retirement. They are on track to retire with enough money in their investment accounts (portfolio income) and they are on track to receive adequate income from their passive (e.g. 401(k) and IRAs) sources.
During this stage, it is possible someone has, on paper, reached the point where they could live their chosen lifestyle on passive and portfolio income but cannot do so for reasons related to withdrawal rules and regulations. Such is the case for me and my wife. I currently receive a pension for my active duty service and our Thrift Savings Plans (401(k) for federal employees) contain adequate funds for us to live our chosen lifestyle. At this time, however, we are too young to draw from those accounts. Additionally, we are both on track to receive pensions from our employer. But again, like the Thrift Savings Plan, we are essentially locked out of drawing that money until age 60. So even though we have the money to retire based on our current account balances, we are effectively locked into working until age 60. Typical age range: 36 – 55
The requirements to be at this stage are pretty straight forward. When people can live their chosen lifestyle on income from their portfolio and passive income sources and no longer require earned income – when they can work or not work at their discretion – they are wealthy. Typical age: 56+
I previously spoke of multiple streams of income. Considering there is always the possibility (probability?) that something beyond the individual’s or couple’s control will negatively impact one or more income streams, more is definitely better. For the Wealthy individual, I would suggest four income streams are necessary. For a couple, at least six streams seems about right to me. Nothing worse than to be a few years into retirement, have a couple of your income streams negatively impacted, and go from being wealthy – as described earlier – to seeking employment to satisfy your monthly expenses.
To be comfortably wealthy, multiple streams beyond the Wealthy threshold are required. I would suggest two additional streams are required in each case; six for the individual and eight for a couple. Typical age: 56+
So which stage are you at? Are you developing multiple streams of income of passive and portfolio income?