Rich people ‘realize’ less income than their ‘middle class’ counter parts, and they are happy about that. To live you need cash flow not necessarily ‘taxable’ income.
So what is ‘realized’ income and what is ‘unrealized’ income?
Realized income is for your salary, rent, interest, dividend, royalty, etc. or any money you have to pay tax on. (ok do not scream, i know dividends are tax free, this is just an example)
You make Rs.400,000 a year, and you get paid the full Rs.400,000 which means you have to pay taxes on it. Now think of it as any time you earn money (even on your investments), and want the hard cash in your pocket at the end of the day. Hard cash, is obviously post tax.
On the other hand, unrealized income is money that you “earn” like when your investments go up in value, but you don’t sell them to book the profits or translate the cash into your bank account, which would turn it into “realized” income. For example if you have a portfolio of equities, say worth Rs. 5 crores, you get a dividend of Rs. 10 Lakhs (realized income) and Rs. 1 crore as appreciation. This Rs. 1 crore (so your portfolio value has gone up from Rs. 5 crs to Rs. 6 crores) is the ‘unrealized’ income. You do not pay any tax on the unrealized income.
To develop a ‘rich mind set’ you need to convert all your unearned income to ‘unrealized income’. This means you pay Income Tax only on the salary / fees / royalty that you earn. It is impossible to differ this income and the company paying you will not agree, so you need to pay tax on that. So if you earn a salary of say Rs. 20L or Rs. 2 crore, you will pay the applicable tax
However if you have a net worth of say Rs. 1 crore – out of which Rs. 80L is in bank fixed deposits – this will lead to a Rs. 8L of ‘unearned but realized income’. You will pay 30% tax on this – amounting to say 2.4 L Rs. This is an amazing waste.
Now if this ‘unearned’ income is converted to ‘unrealized’ income you will earn the money but pay no tax as it is ‘unrealized’! This is legal and should be done.
How is this possible?
- One by changing the asset allocation: If this person were to invest Rs. 50L in equities, the ‘realized income’will be dramatically reduced – dividends – to say Rs. 1L. Say at the end of the year the portfolio is up by say Rs. 6L. So at the end of the year he will have a portfolio of Rs. 56L, and cash of Rs. 1L. In India currently, this 1L is tax free. The balance Rs. 30L can be invested in a short duration bond fund – with say a 2 year duration – growth option. This will also appreciate and will have no income tax implication.
- If the client has no appetite for equity, the whole Rs. 1 crore can be put in a bond fund Growth scheme and defer the income to say a day 15 years away. This allows you to dramatically harness the power of compounding.
Simple steps, but it requires a Rich Dad mindset. Millionaire mindset as we say….
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