Understanding the Tax Game, Part 1 - The Cashflow Quadrant

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I love the film Hoosiers. Not just because it’s a great Cinderella story, but because it has so many great lessons to be learned. Lessons about the values of fundamentals.

The basketball coach in the film is a relentless fundamentalist of the game. For example, he obsesses over his players making “three passes!” before anyone takes a shot. This is initially met with outcry from the fans and rebellion from the team, but as the film progresses the coaches commitment to the fundamentals wins his team over…all the way to the championship.

I’ve been thinking recently about some of the fundamentals of another game—the tax game. Few of us actually look at taxes as a game (rather, a complete headache), but the game becomes much easier—perhaps even fun—when the principal rules are understood.

I’d like to spend some time over the next month or two to help you understand a few fundamentals of the tax game. They are something that even a young teen can understand, but they can make a huge impact on your financial life and overall wealth.

You Don’t Need to Know All the Particulars

I loved this quote I recently saw about knowing the fundamentals.

"When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles."

This should bring a huge sigh of relief to anyone worried about personal finances feeling too complicated. Yes, there are lots of tiny, granular rules, laws, and guidelines. But you don’t need to know all of those things. What you need to know are the “core principles” that will help you navigate the complexities.

Let me tell you about a tax “core principle” that I was recently reminded of. Knowing this will make you better prepared to play the tax game.

The Cashflow Quadrant

This concept was popularized in Robert Kiyosaki’s book of the same name. The Cashflow Quadrant is illustrated below.

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This illustrates the four ways you can earn money, or cashflow. The two on the left are more time-intensive ways, either working at a job as an employee, or being self-employed. You can earn good money in either of these areas, but you’re trading money for your time.

The two on the right are less time-intensive (more passive), either employing others as a business owner to do your work and provide cashflow, or using investments--like real estate, stocks or bonds--to provide you with cashflow.

Choose The Right

Most people are on the left side of the quadrant, but our aim should be to get more to the right side. Doing so not only increases our passive income (freeing up our time), but the tax code is more favorable for the right side as well. In what ways? Here are a few examples:

  • Current federal income tax rates (2018) are between 10% and 37%, depending on your income. However, long-term capital gains rates (for assets like investments or real estate held for the long-term) are between 0% and 20%.
  • Most household expenses aren’t deductible. You can’t, for example, deduct the expense of your car from your personal income. However, businesses can deduct a wide variety of expenses from the income of the business, which can lower the businesses income taxes.
  • The recently passed Tax Cuts and Jobs Act allows for a qualified business income tax deduction of an additional 20% for eligible businesses. You can learn more here.
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In Uncle Sam’s view, when you build businesses and invest, you’re not only making yourself better off, but you’re benefiting others and creating new jobs. The IRS is willing to offer you tax incentives, like deducting business expenses or deferring taxes on investment gains in a retirement account, to encourage these types of investments.

I hope Part 1 of Understanding the Tax Game has been helpful for you. I love the simple yet profound information the Cashflow Quadrant illustrates. As you earn income, think about ways you can move more towards the “right side” of the Cashflow Quadrant. This can be as simple as opening a 401k or IRA account and contributing each month, or something as involved as starting a business. Whatever you fancy, remember that part of playing the tax game well is to “invest and grow” rather than just “earn and spend.”