Dave Lukas - Lessons for Hannah
185: Lessons for Hannah - 5 Very Important Financial Lessons
Hello Misfit Nation! Welcome to another edition of "Lessons for Hannah!"
In November of 2016, we introduced a new format that we are putting alongside our regular episodes called “Lessons for Hannah.” Hannah is my daughter and one of the main inspirations for the Misfit Entrepreneur. I wanted to have a place where she could go and learn from her daddy and his Misfit friends throughout her life….even after I am gone. If you haven’t listened to the first episode of "Lessons for Hannah," I urge you to as it gives some more background and tells the amazing story of how Hannah came to be in our lives.
"Lessons for Hannah" are short, very useful, and sometimes comical lessons, that I have learned which I want to share with you and give to Hannah to help in your lives. Because I want Hannah to have these for her life, I’m going to speak as though I am talking directly to her. These episodes are a lot of fun and if you think there is a lesson that we should include in these episodes, please don’t hesitate to send it over to us at email@example.com. We’d love to share it.
This week’s Lesson for Hannah
I want to talk to you about 5 very important financial lessons that I wish I learned earlier in life. I’ve done my best and will continue to do my best to teach these and others to you as you grow, but I wanted to put them all in one place for you in this episode.
Your financial education is probably the most important piece of your learning journey. Understanding the language of finance and how taxes, income structures, debt, and how a host of other financial areas work is something that most people never put much time into. This may be because our school system doesn’t really teach these things, unless as an elective or unless you make your career in finance. But, even then, much of the financial education required to thrive in the real world is not taught.
There is so much I can share with you about financial education that I could spend months just doing episodes on it. Thankfully, I’ve got years to teach you, but here are 5 very key lessons that are at the heart of what you need to learn.
#1. How You Make Money is Much More Important Than How Much Money You Make
Most people just focus on “making more money” in their lives when, it is never how much you make, but how much you keep that matters. And because most people make their money as employees, there is not much they can do about this because they don’t have any control. A W2 is the highest taxed form of making money. And not only is it the highest taxed, but you must pay the government before you get any of your money.
Let’s contrast that with being an owner of a business and deriving your income from that business. Now, there are a lot of different business structures that differ by country around the world, but as I teach you this, there a few predominant ones for small business owners in the U.S.. These are an LLC, closely held S-Corporation with 1 or 2 owners, and a partnership or limited partnership. These entities all have about the same tax benefits, but from a legal standpoint can be used in different ways. When you are an owner in one of these entities, the tax laws favor you. First, you don’t have to take all your income as a W2 type income. In fact, in the case of the S-corp, you take what is called a reasonable salary as a W2 and then the other income you earn from the profits of the business are taxed differently – effectively almost 15% less.
More importantly, the business allows you to deduct expenses and items that you use for it. So, for example, if you are a W2 and you want to buy a computer for your work at home, you really can’t deduct that, or maybe only a small portion on your taxes. As a business owner, you can deduct the full amount.
On top of that, you get paid first – not the government. For the profits your business earns through the year, you get to utilize that money as you see fit and then at the end of the year, you pay tax on the amount left after investing in and paying for your business. This allows you to have your money work for you instead of being taken every paycheck.
I know this is a very simplistic example of the difference between a W2 vs. deriving income as an owner of a business, and there are actually many other benefits to creating income as a business owner- what I most want you to understand is that it is not how much you make, it’s how you make it that matters. If I make $100,000 from my business, I will take home a lot more than if I make $100,000 as a W2 employee.
#2: The Super Wealthy Make their Money Predominantly Using 3 Mediums: Owning Businesses, Real Estate, Stock market
Following on our last example, if you study the Forbes 400 wealthiest that is listed each year, you will see they overwhelmingly make their money in either being a business owner, investing in real estate, or investing the stock market. Most do all three to some degree.
As I got into my career, it dawned on me that if that’s how the super wealthy make their money, I might want to pay attention to it. I was already on the path of entrepreneurship, but It was then that I started to study real estate and the stock markets.
And what I learned about these areas was shocking. There are so many opportunities and ways to create wealth. In real estate, you can purchase rental real estate, or buy tax lien certificates, invest in developer projects, flip houses, and host of other types of transactions. In the stock market, you don’t just have to buy a stock or mutual fund, you can use options or sell and write option contracts. You can do all kinds of different trades, including my favorite, selling naked puts and credit spreads, which pay you up front for even taking a risk with your money in the market, as well as put the odds of winning in your favor. Buying a stock or mutual fund gives you none of that.
It literally pays to learn about these different areas of finance and business, so learn all you can.
#3: Rental Real Estate Offers the Best Tax Benefits
Owning businesses and investing through tax advantaged business owner specific IRAs gives you some great tax advantages and leverage, but unless you have an army of lawyers to pour through the tax code each year and find every little thing you can do to maximize your wealth, the best tax advantages I’ve found are in rental real estate.
Real estate has incredible advantages as long as you are willing look at things long term and are willing to hold. That doesn’t mean you don’t get a benefit in the short term in creating cashflow from rents, it just means that the biggest benefits come over time. For example, rental real estate allows you to deduct an expense each year called “depreciation.” Basically, what it means is that you can deduct 1/27 of the value of your property each year for 27 years. Now, why does this matter, first, it is an expense you get to take without actually paying money from your pocket. You are essentially taking a deduction for your property getting older each year. This will then act like an expense against your rental income alongside your mortgage (if you have one), taxes, other expenses, etc. And like a business you get paid first and take deductions and expenses before you pay the government. Depreciation is almost like phantom income as it allows you to keep more of your rent tax free. Now, there are rules that when you go to sell a property, depreciation comes back to be taxed as part of your profits, but even then there are things like carryover than can go against it and one of the biggest tax benefits of real estate, the 1031 exchange.
1031 is an area of the tax code that basically says, if you sell a property and take the proceeds and invest them into a new property of greater value, the proceeds or profits can roll into that property tax free. In fact, many investors just keep using the 1031 laws to roll their gains over and over into new and larger properties over time.
Now, why does the government allow this with rental real estate? Because people need a place to live and the government incentivizes investors to help make that a possibility.
Again, these are simplistic examples and there are a ton of other tax advantages to real estate, but these two alone make it one of the best investments out there.
#4: 401k’s Are Not as Good of an Investment as You Think
If you are a W2 employee, you pretty much have no other choice but to invest in a $401k for retirement and when the market is good, then your 401k is good, but have you ever looked at how broker fees and expense ratios eat away at your profits over time? Tony Robbins did a great job exposing this in his book, “Money, Master the Game.” A good read for those wanting to improve their financial education. But, did you know as a business owner, you have a lot more options. You could do what’s called a Solo 401k in which you can choose the investment choices, lowering the fees, and put over $50k per year away tax free? Or you can do a Simple or SEP IRA that allow you to have total control over how you invest and what you invest in including things like real estate or physical gold. And these IRA’s allow you to invest 10’s of thousands as well each year.
What I want you to understand is that when it comes to your retirement, there are much better ways to save and grow your money than a 401k, but you need to be a business owner to use them.
#5: Keep Your Cash Working for You, Otherwise, It’s Basically Worthless
We’ve all heard the phrase “Cash is king,” and while yes, in rough times, cash can be very useful in a number of ways, the realty though, is that if you are not putting your cash to work for you, it is losing its value every day. It’s called time value of money and every day; money is worth less than it was the day before if it is not generating enough to keep up with inflation. In fact, since 1913, the dollar has lost 96% of its value. That’s right one dollar in today’s dollars is worth $.04 priced in 1913’s dollars.
So, if you are stashing a ton of money in the bank at effectively 0% interest, each day it loses some of its value.
This doesn’t mean you shouldn’t hold some cash. I advocate having a “rainy day fund” that you don’t touch unless for emergencies that is at least 6 months’ living expenses, preferably one year if you can do it. But, once you have your rainy-day fund in place, you should look to put your money to work for you.
And you must be diligent about it. I’ve shared a number of concepts in this episode, but each one of them takes knowledge, skill, and good judgment to execute successfully. Just because you have been able to make and save some money, doesn’t mean you can’t lose it. And there are always those out there looking to separate you from your money – so make sure you keep up on your financial education.
Hannah, If I had learned these lessons even one year earlier in my life, they would have made an even bigger difference for me than they already have. It’s important that you commit to your financial education and learn all you can starting as young as possible. The lessons you learn, whether you use them immediately, or at all, will still prove to be invaluable for you and help you throughout your life. And I’ll be there to help you and teach you as your grow.
I love you,
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