I credit Robert Kiyosaki in his seminal book ‘Rich Dad Poor Dad’ with identifying and defining the 4 basic types of employment; (1) Employee, (2) Self-Employed, (3) Business Owner and (4) Investor. It was the first time that I had actually seen someone memorialize the difference in the 4 types of employment that was available to us in our capitalistic system and define the pros and cons of each type.
Why is this such an important aspect as it relates to wealth building? As I appreciate much more now that I have lived it myself, it’s important because it is the absolute most basic element as to IF wealth will be built and how QUICKLY.
To make this point let’s start by reviewing the aspects of each type of employment. Let’s start off with being an Employee.
Only 18% of individuals are entrepreneurs or self-employed
In something I came across recently, the data shows that roughly 82% of all Americans that are in the workforce are employees. W-2 workers as they are called.
This is most of us from secretaries to lawyers to even doctors. These are the people who go to work everyday for someone else. They get their paycheck by providing value to someone else’s business or organization.
It’s REAL hard to become wealthy as an employee
When I was a younger person thinking about wealth creation, I assumed that because everyone else was an employee that the majority of wealth building was being done from within this type of employment.
Let’s face it, with roughly 82% of all Americans receiving their compensation within this category (it’s estimated that 18% of Americans classify themselves as self-employed) how could it not be the predominant way wealth was created? Probably no surprise to anyone of you, I could not have been more wrong.
Although the number of individuals who have become millionaires has been increasing over the past decade due to rising real estate values and the growth in the stock market it is still a much lower percentage of millionaires who got there working for someone else.
In fact, research shows that a self-employed individual is 4 times more likely to become a millionaire than someone who works for someone else.
W-2 workers have no leverage
Why is that? Multiple reasons in fact. As we have talked about in multiple posts on this blog, when you work for someone else you have absolutely NO leverage!
Your day’s work does not have any multiplying force for you, as you get paid only for those hours you work.
There is no residual income that you derive from working for someone else. You are also taxed immediately when you earn your wages through payroll and income tax.
Self-employed individuals have more lucrative tax deferred options
In addition, you also don’t receive as favorable a treatment on tax deferred investing as self-employed individuals, a total allowance of $19,000 annually ($6,500 over 50 years old catch up) for W-2 workers versus approximately $63,500 including the over 50-year old catch up allowance for self-employed individuals. The DoughRoller has some great insight on this in his post https://www.doughroller.net/business/small-business/11-financial-benefits-self-employed/
The other aspect is that you can’t pass the ‘equity’ that you build in a job onto anyone in your family. You also can’t set when you work and what you work on. All you get from working for someone else is compensation for the time that you work and nothing else.
So what’s the deal with Self-Employment? Well, there’s a big argument that if you can’t be anything else being self-employed isn’t a bad thing to be. For example, when self-employed you are for the most part making all the decisions. You decide what you take for work, who you work with, who works for you, when you work and how long you work.
Being able to deduct expenses before taxes
Another significant advantage being self-employed has is that it allows for deductible expenses to be made prior to being taxed. (More information is provided in this post https://thefinancialstoic.com/?p=321
As such, a business gets to deduct expenses such as cell phone service, internet, office lease, vehicle payments and other expenses incurred in generating income before being taxed on the profit.
Obviously, these same expenses if they’re being incurred by someone who is an employee are simply living expenses and are paid with after tax dollars at that.
So what are the downsides to self-employment? Well, for starters if it is just you there is nothing to hand down to your family or sell to interested parties.
Also, if it is just you in the business you don’t make money unless you are physically working in the business. That means when you go on vacation you’re not getting paid.
In addition, if you are a highly credentialed professional such as a doctor, lawyer or CPA even though you have probably enjoyed a lucrative lifestyle for you and your family the chances of your children being able to take over the business for you are fully dependent on them obtaining the same credentials that you have.
Make money while you’re not working for it
Now what about being a Business Owner? The nuances of being a Business Owner are such that you have a system that is set up to make you money when you are not even physically at the business.
In fact, a business owner should still be able to make money even if they are detached from the business as long as they have competent professionals and employees tending the business on their behalf.
You also have the benefit of leverage in the form of Other Peoples Time (OPT) by having employees of your own and Other People’s Money (OPM) through the receipt of loans from the bank and investors.
It’s also the first type of employment opportunity where you can make money when you’re not there, taking into account that employees can work on your behalf and utilize business systems that you’ve developed.
You can also sell the business or be able to hand it down to your family if you have employees and a business system.
Businesses sell for a multiplier of sales
One of the other top benefits of being a business owner is that the business has ‘good will’ which creates value beyond just the sales volume and value that is being done through the business. As such, many businesses sell for a multiplier between 3 and 4 times sales with other businesses like software fetching even larger multiples.
As a distinguishing characteristic, a business owner is someone who maximizes leverage from being able to utilize OPM and OPT and has the same highly favorable tax advantages of being self-employed. In addition, as a business owner you get the same ability to deduct expenses as being self-employed.
Essentially, being a business owner has all the same beneficial advantages of being self-employed but the overriding benefit is that you should be able to spend a small portion of your time actually running the business, instead hiring other individuals to do so on your behalf.
This allows an individual to be in a position to own multiple businesses and reap the benefits financially. When that happens, you’re now able to fully realize the leverage of ‘economies of scale’ by being able to hire for an example a CPA or an accountant and have them oversee several businesses at a time.
An Investor is the apex wealth builder
Now can anything top being a Business Owner? Not much but being an Investor is surely the last type of employment and the one which is by far the best of all four.
For starters, an Investor is fully independent from each business that they might invest in. They are not responsible for running the assets that they own, simply responsible for their holding company that owns the assets.
As such, they do not need to physically be part of any of these businesses on a day to day basis nor do they need to otherwise put the time in doing the work in these businesses that generate the wealth (one exception might be whereby an investor owns real estate and ‘actively’ manages it for themselves).
So above and beyond all the same benefits of business ownership, Investors accrue another by far advantage that none of the other types of employment get; taxation.
In a nutshell, an investor is getting taxed on income derived from an underlying business asset. This is usually derived in the form of a dividend payment which is considered ‘unearned income’.
As such, unearned income is taxed at a different level than ‘earned income’ which is income earned from a W-2 job or self-employment. The tax rate for unearned income is by and large currently 15%, the capital gains rate, in the United States. Here’s another interesting benefit, unearned income is also not subjected to payroll taxes or employment taxes such as Social Security or Medicare taxes.
Conclusion
The bottom line is being an Investor has ALL the benefits of the previous business ownership benefits AND enjoys the enviable position of having a substantially lower tax rate.
Why is this? Why are W-2 earners ‘punished’ by the system and those individuals generating unearned income rewarded?
I’m not sure I truly know the answer but having been involved in a career in economic development for over 20 years here’s my thought;
The government wants to encourage individuals to create jobs and build wealth and economic activity for their community so that they will not have to provide costly services for residents AND they’ll incentivize individuals to do it!
That is basically the reason that being an Investor is heralded by the system in the way that it is and why it receives favorable treatment over the other forms of employment to the degree that it does.
So if you REALLY want to buck the trend, try to move up the employment totem pole as quickly as you can and if at all possible, skip the Employee rung. If that’s not possible, don’t hang around there any longer than you need too!
