The Game of Becoming Rich

Since it’s college football season, I have been thinking about a metaphor for money. Becoming rich can be described as a game, with both offense and defense.

Offense is income or revenue. High earners are like a high-scoring offense, throwing for 400+ yards per game, rushing for 200+ ypg, and putting up 65+ points on their opponents in front of cheering alumni and a raucous student section.

If we are not yet earning what we would like to, we can focus on and improve our offensive strategies. To improve our offense, we can increase our earning potential through certifications and degrees; we can take second jobs, consulting gigs, or side hustles. We can always be looking for ways to score more points and bust one out in the open field.

Defense is expenses, including debt payments and taxes. Good defenses contain the running game, pressure the quarterback consistently, and never allow big plays into the secondary. Frugal living, prudent investing, and minimizing tax-liabilities would be hallmarks of a strong defense.

Many high earners give up too many yards and points per game simply by increasing their expenses and leading a fancier lifestyle. This ‘lifestyle creep’ can come in many forms: leasing cars, financing or purchasing high-end furniture and appliances, buying boats or RVs, etc.

High earners who give up a lot of points on defense may think that it’s okay to do so, since they are very strong on offense. The problem with that mentality is that victory is really all about the margin.

If you think that a last-minute, skin-of-the-teeth, hail-Mary pass to win is fun to watch in football, you are right. However, in finance, this scenario is analogous to someone hoping to win the lottery or hoping that a relative leaves them a load of money on which to retire.

A team playing-from-behind in football may relate to someone living beyond their means their whole lives, with the hope that at 65 years old, some government entity or third-party will step in at the last second, so that they might be able to retire. Sometimes there is a last second victory, many times there is not.

How much better would it be, and how much less stress would you have, if instead, your offense put up 50+ points on your opponent in the first half, AND held your opponent to 10 or less. That would free you up to sit your starting quarterback in the 3rd and 4th quarters (stop working second jobs or side hustles, go down to part-time work, or retire completely and stop working for money all together). You would keep your first-string defense in the whole game (not living a high-consumer lifestyle and minimizing tax liabilities), thereby allowing a comfortable margin of victory at the end.

Victory is all about the margin. If you have a high-powered offense, that is great. But in finance, as in football, defense wins championships.

Becoming Rich: IRA or 401k

There are some great aspects of being a high earner, but one downside is that often, people who are high earners are expected to save for their own retirement. Seldom are there great paying jobs that also have a pension or some guaranteed income after a certain age. So while the getting is good, we need to sock away a lot for our golden years.

There are many options these days for how to save for ‘retirement.’ (I use that term here because it typically applies to age 65+, and many of these monetary tools are designed for that age. I fully expect to retire at age 45, but the tools we talk about in this post won’t cover the gap between 45-65 years old.)

I initially began searching for a great retirement vessel when I realized how little social security pays out now and also the likelihood that it will not be adequately improved by the time I turn 65. Also, my tax advisor recommended retirement savings as a great way to reduce taxable income.

I did some research and weighed the fees associated with plans versus the tax savings in the possible contributions. Since at the time I was doing this, I was in the “save a little here and there and hopefully retire at 65” mindset, I went with a SEP-IRA. This allowed me to put some in for both me and my wife (she’s an employee of our corporation), and give some profit sharing to any eligible employees. Everything seemed fine, until we actually had to do the contribution at the end of the year. A SEP-IRA allows an employer to contribute up to 25% of an employee’s earnings, up to about $50,000. I had to match percentages to each person who qualified, meaning if I wanted to bonus myself 10% of my salary, everyone would get a 10% bonus. That became very expensive, not just because of the bonus, but because if I wanted to max out the contribution, I would have to pay my salary entirely in W-2 earnings, versus shareholder distributions through the corporation.

W-2 earnings are subjected to all the Medicare & Social Security taxes, and since I am my own employer, I would have to pay both halves of those taxes.

I wanted the tax savings, so I bonused 10%. But since I hadn’t paid myself in only W-2 wages, I couldn’t maximize my retirement contributions and tax savings.

There had to be a better way.

The following year, I had started turning around our financial outlook, and I met with a financial planner. He introduced me to the Safe-harbor 401k. I had read about 401k’s when researching the year before, but decided against it due to the seemingly high fees. My advisor laid out how we could save up to $18,000 each into the 401k, while only having to matching qualified employees up to 4% (if they choose to contribute as well). I could divert the wages I was already paying myself and my wife into the 401k plan, and would not have to pay myself or my wife any additional W-2 wages. If we increased our W-2 wages, we would in turn increase our FUTA or FICA taxes. We added a profit-sharing option, with similar rules to the SEP about equal percentages for each employee. But it was simply an option we added to the plan in the event that no employees qualified; then we could sock even more into the plan.

I had always thought that a 401k limited your savings to the 3-4% that the employer matched. I am glad to be wrong.

Last year, with no qualifying employees except my wife and myself, we were able to invest $18,000 each, plus the 4% match, plus a 25% profit sharing contribution for a total of nearly $55,000 of pre-tax dollars invested into our 401k. Being that our effective tax rate (fed + state) is close to 30%, we saved approximately $16,500 in taxes by using this strategy. Well worth the fees associated with administrating the plan and the higher expense ratios we have as options in the American Funds plan we have. (I plan to utilize American Funds while I am working. When I retire early, or don’t have to contribute any more to my 401k, I plan to roll them over into lower cost Vanguard funds.)

So even though high-earners are responsible for our own retirement savings, there are some great vehicles to help us along the path. We just have to find the right tool, and maximize it.