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The Beginner's Guide to Personal Finance from Rich Dad - Part 2

In the first part of our beginners guide to personal finance I explained how to budget your money using the Pay Yourself First philosophy utilizing a personal financial statement. I then explained why saving money is no longer going to provide a secure retirement and how investing is the key to true wealth.

In the conclusion of our personal finance guide, I'm going to explain why not all debt is created equal, how your credit score affects your wealth, why taxes are the key to generational wealth and how you can retire young and rich.

The Beginner's Guide to Personal Finance

  1. Part 1

    1. Budgeting

      1. Pay yourself first

      2. The personal financial statement

        1. The Income Statement

        2. The Balance Sheet

    2. Saving isn’t investing

      1. Assets vs liabilities

      2. Cash flow vs capital gains

      3. Why investing beats savings

  2. Part 2

    1. How to use debt

    2. Your credit score

    3. How your income is taxed

    4. Retire Young, Retire Rich

    5. Rich dad's personal finance tips

C. How the rich use debt to improve their personal finances

If you were raised with conventional wisdom surrounding money, you probably just balked at the sentence I just wrote. How could the economy reward people in debt? Isn’t debt evil?

The short answer is no. The long answer is it depends.

The key is to understand that there are two kinds of debt: good debt and bad debt .

Bad debt is used to purchase liabilities that do not provide cash flow. These are things like cars, vacations, personal homes, etc.

Good debt is used to purchase assets that put more money in your pocket each month than the cost of the debt takes out. These are things like investment properties, capital investments in your business, investments in product development, etc.

One of the keys to the Rich Dad personal finance philosophy is understanding debt and using good debt to get rich.

Bad debt, of course, should be avoided, as any financial advisor would say. And if you have bad debt, you should pay it off quickly, but good debt is something you should embrace. The reason for this is simple, you can accelerate your return on investment (ROI) by using debt, aka Other People’s Money (OPM), to purchase assets. This is because you have less of your own money in an investment, but you still enjoy the cash flow from that asset.

You can learn more about OPM in this blog post that I wrote called, “ Rich Dad Fundamentals: Other People’s Money (OPM) ” In that post I show how you can change your ROI from 12.5% to 50% on the same asset just by using good debt.

D. Your credit score

The key to using good debt to get rich is having good credit. This is a foundation of any personal finance philosophy and is for us too.

Simply put, the higher your credit score, the easier it is to get debt, better terms on that debt, and insurance to protect your investments.

Credit is scored on a scale between 300-850, and there are four major credit agencies that calculate your credit score. A score above 700 is considered good and anything above 800 is excellent.

According to Equifax, a major credit scorer:

In general, here are the factors considered in credit scoring calculations. Depending on the scoring model used, the weight each factor carries as far as impacting a credit score may vary.

- The number of accounts you have

- The types of accounts

- Your used credit vs. your available credit

- The length of your credit history

- Your payment history

The easiest way to improve your credit score is to reduce your bad debt and to pay your creditors on time (or negotiate with them for extensions as you pay yourself first).

This takes emotional intelligence, as I mentioned before. If you have emotional intelligence, you’ll be able to say no to impulse buys for liabilities that will ultimately hurt your credit score. If not, well, you’ll probably never get rich.

E. Three types of income and how they’re taxed

I’ve already spoken to taxes in this guide to personal finances, but specifically I want to share with you the three types of income and the different ways those incomes are taxed.

For most people, they believe paying taxes is simply a part of living in a civilized society. And while that’s true, not everyone is taxed the same.

Below, I will explain how the three different types of income are taxed and why.

  1. Ordinary income

    As we discussed earlier, ordinary earned income is money you make from your job such as wages, tips, and your salary.

    In an attempt to make things even between the different tiers of society, the government has set up varying levels of how much people will pay in taxes.

    Tax brackets, as they are called, tax people within each bracket at different percentages. For example, in the United States, if you make under $9,525 per year, your tax rate is 10% of your taxable income. If you make between $9,526 and $38,700 per year, your tax rate is 12%. There are varying tax brackets all the way up to individuals that make up to $500,000 per year, who are taxed at a high 37%.

  2. Portfolio income

    Portfolio income is made through capital gains.

    Unlike ordinary earned income, portfolio income is a tax on how much money you made on the sale of your asset. The tax rate is determined by how long you held the investment and how much income you made during the tax year.

    For instance, if you owned a rental property for more than a year and decided to sell it, you would be taxed anywhere from 0% to 20%. This would be called a long-term capital gains tax.

    There are also short-term capital gains tax (taxes applied to profits from selling an asset you held for less than a year) and property sales tax which are governed by their own set of rules.

  3. Passive income

    Passive income is money that comes in consistently from an asset.

    One of the reasons my rich dad encouraged me to invest for passive income is because of the amazing tax benefits it provides.

    Passive income is taxed at the lowest rate of the three types of income.

    For example, if I own a rental property, I make passive income every month. Not only do I make money through rent, but the passive income I put in my pocket is taxed at a very low rate, if at all.

The figures presented in this section were for education purposes only. Please consult an accounting and tax specialist for rates specific to your country or state.

F. Retire young, retire rich

Ultimately, any personal finance philosophy would be incomplete without discussing retirement. Everything we’ve talked about up to this point will position you to retire well, but I want to leave you with a few Rich Dad fundamentals around retirement to wrap everything up.

The rich don’t work for money

This statement probably comes as no surprise based on what we’ve talked about so far, but it’s very important to understand that a secure retirement is one where money works for you via cash-flowing assets . There is nothing quite as comforting as knowing money will come in each month whether you are working or not.

The rich don’t save for retirement

Most personal finance experts will tell you to invest in a balanced portfolio of stocks, bonds, and mutual funds. The problem with this advice is that these are lousy ways to save and prepare for retirement . Primarily because the companies that help you save in these vehicles charge many hidden fees that eat into your returns. In addition, you have no control over those vehicles, and you take on all the risk while they get all the rewards.

If you are currently enrolled in a company sponsored retirement plan like a 401(k), I advise you to look at the fine print and consult the manager of your company’s fund.

You might be surprised to learn how many fees are being taken out of your retirement account every month regardless of whether or not your investments made money.

Your wealth number and retirement

Here is a simple question for you, “If you (or you and your partner/spouse) stopped working today, how long could you survive financially?”

Sadly, most people couldn’t answer that question off the top of their head. Luckily there is a simple way to determine this, which we call the wealth number. Here is the equation to determine your wealth number :

Your wealth number = Your available money / Your monthly expenses

In this equation, your available money equals the money you have on hand if you stopped working today — not what you make in earned income. Your monthly expenses are your current output each month. This includes anything in your savings and checking accounts, retirement funds, emergency funds, etc.

If your wealth number is 10, that means you have 10 months to live on based on your current money divided by your expenses. If it’s 6, you have 6 months and so on.

Most people, even if they are what would be considered rich, have a finite wealth number. The truly rich, however, have an infinite wealth number. The cash flow from their assets covers their monthly expenses. So, they don’t have to work if they don’t want to. That is the number for the rich when it comes to retirement.

The rich use the three piggy banks to retire

A natural question is how much you should put aside each month for retirement. The short answer is 30% of your income, ultimately. But, of course, start with what you can and work your way up if need be.

The long answer is, again, the three piggy banks:

  1. Savings Account (10%)

  2. Investing Account (10%)

  3. Charity or Tithing Account (10%)

G. Rich Dad’s personal finance budgeting tips

I hope you enjoyed this Rich Dad guide on personal finance. As you can tell, our approach is very different than the conventional wisdom on money, but it’s built for getting rich in today’s economy, not the one of your parents.

In closing, I want to leave you four simple tips to budget like the rich:

  1. Start paying yourself today

  2. Complete a personal financial statement once a month and make adjustments as necessary

  3. Follow Rich Dad’s six simple steps to get out of bad debt

  4. Use emotional intelligence to avoid liabilities and save for assets

If you follow these simple steps, you will retire young and rich, just like Kim and I did.

Original publish date: June 12, 2012