I recently read the book titled The Millionaire Next Door, The Surprising Secrets of America’s Wealthy by Thomas J. Stanley and William D. Danko. The book was published in 1996 but applies just as much today as it did nearly 25 years ago. It was eye opening in that it explained the difference between two different types of high-income earners, and which type we should strive to imitate.
When you think of a stereotypical millionaire, thoughts of mansions, fancy cars, and expensive trips probably come to mind. Thomas Stanley conducted a national study of the millionaire population in America back in 1980. What he discovered was the majority of millionaires live in middle-class or even working-class homes, drive sensible cars, and would rather put their hard earned money to work in a retirement fund than go on expensive trips around the world. This type of millionaire is the secret millionaire, or the millionaire next door. Their neighbors probably have no idea they are living in the midst of a millionaire because they don’t live a typical millionaire lifestyle. In fact, being sensible with their money is what allowed them to achieve millionaire status in the first place.
High Income Earners
High income earners fall into two categories:
1. PAW – prodigious accumulator of wealth. They excel at building net worth in comparison to others in their income/age category.
“Great offense in economic terms means that a household generates an income significantly higher than the norm. Many of these households also play great defense. They are frugal when it comes to spending on consumer goods and services.”
“The foundation stone of wealth accumulation is defense, and this defense should be anchored by budgeting and planning.”
2. UAW – under accumulator of wealth. They spend as much as they make, if not more. Focus is on consumption and not on the practices of wealth building.
“They believe in spending tomorrow’s cash today. They are debt-prone and are on earn-and-consume treadmills.”
“UAWs consider cash/near cash and equivalents, such as savings accounts, money market funds, and short-term treasury bills, to be investments. They are nearly twice as likely as PAWs to hold at least 20 percent of their total wealth in cash/near cash. UAWs hold a larger percentage of their wealth in motor vehicles and other assets that tend to depreciate.”
Minimizing taxable income
Some other nuggets of information I gleaned from this book had to do with the strategies a prodigious accumulator of wealth (PAW) uses to become a millionaire. For example, they focus on minimizing their taxable income and maximizing their nontaxable income. They do this by investing their pre-tax dollars in retirement accounts. This is income that an under accumulator of wealth (UAW) would rather spend and enjoy now. Because they are not taking care to shelter their income from being taxed, they end up with even less money to spend and enjoy. And there is no money invested in the future.
Family Matters
Children of UAWs suffer in their adulthood because they receive money and other financial gifts from their parents until they are in their forties and fifties. They never learn financial independence or how to manage their money well. They also don’t have good relationships with their siblings because they are constantly competing for their parents’ wealth. On the other hand, children of PAWs learn to earn and invest early in their adult life, giving them an opportunity to be self-sufficient and have healthy relationships with their family members.
There is much we can learn from Thomas Stanley’s study which still holds up today. Perhaps he put it best when he said “Being a well-educated, high-income earner does not automatically translate into financial independence. It takes planning and sacrificing. Your plan should be to sacrifice high consumption today for financial independence tomorrow. Every dollar you earn to spend is first discounted by the tax man.”
Calculating Wealth
Want to know how to determine if you’re wealthy? According to The Millionaire Next Door, it’s a simple calculation. Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by 10. This, less any inherited wealth, is what your net worth should be.
For example, if a 40 year old single woman makes $100K per year, her ideal net worth would be calculated as follows.
40 x $100,000 = $4,000,000
$4,000,000 / 10 = $400,000
Give this calculation a try and see if you’re on track to become a prodigious accumulator of wealth. If you’re not, don’t worry! There’s always time to turn it around. Just start applying the principles of a PAW to your financial life and someday you too can become the millionaire next door!