Good Friday morning my friends!
I’ve been a bit unfair over the last few weeks — I quickly glazed over my thoughts on what constitutes “income” and how you should count anything that improves your personal net worth as an “income”.
I truly think this is the best way to look at “income”.
But this doesn’t capture the full breadth of the income picture. And it may also set some folks down an inappropriate path.
If I were my audience, I think I’d find myself having to be a little more cautious.
Liquidity and Income: A Primer
On the face of it, anything that increases your personal net worth should be deemed “income” — at some point in time, you’re going to sell everything on your personal balance sheet and you’ll take the resulting gains as cash income. By declaring non-cash increases to the values of your assets as “income” as you go, you’re effectively spreading the income out over the years you’ve earned it.
The increase in value of your principal residence doesn’t put food on the table.
Or put another way: Many asset gains are non-cash gains that only become cash when you sell.
This can put some folks in a tough spot.
Some individuals grow their net worth on a cash-heavy basis, such as unincorporated self-employed individuals or high-salaried individuals working in healthcare, tech, or business. In the case of self-employed individuals, gross revenues flow in and provide large amounts of untaxed cash, providing more liquidity for putting food on the table (and a potential tax bill in March or April). High-salaried individuals may have pension plans which keep more cash out of their personal bank accounts, but high salaries tend to lead to higher net paycheques and an easier time when paying the credit card bill.
There are other types and structures of income that will lead you to liquidity crunches though.
Real estate investments result in large non-cash gains throughout your period of ownership. There may be rental income, which generally pays down a mortgage of some sort, resulting in low to nil cash flow. And the appreciation of the property’s value also improves your net worth, but doesn’t become cash until you sell.
This real estate investment idea is at the top of my mind right now. Rental income as a percentage of a property’s value has declined significantly over the last few years, resulting in negative cash flow for a good chunk of the investment's early life. So while your personal net worth grows on a monthly basis, you're actually having to dole out cash to meet the property's operating needs.
The result is a scenario where you may have sizeable net worth increases (or “income”, as I’ve put it) but you may not have the cash in your bank account to sustain a higher-cost lifestyle.
Deferred vs. Current Income
In the accounting and tax world, deferred income is income you’re going to bring into your personal life (and usually onto your personal tax return) at some point in the future.
But in the personal finance world (read another way: my way of thinking about personal finance), deferred income is simply an asset that’s growing alongside your current income, or the current amounts of income you’re earning, paying tax on, and seeing in your bank account.
Deferred income grows your personal net worth now, but does not increase your bank account now.
Current income grows your personal net worth now and increases your bank account now.
Having a combination of the two is healthy, but the more you skew towards the deferred income side, the more you need current income to maintain your current lifestyle as you wait for those deferred items to turn into cash.
When it comes to personal finance writing, the greatest fear I have is that of leading someone down a harmful path. I want to improve everyone’s relationship with money and help them understand how they’re financial picture is growing without them even noticing.
But if you become too reliant on this, you could end up in my shoes — I find myself in a situation where 30% or more of our family income is tied up in deferred income assets. Those assets may increase my family’s net worth, but they don’t put groceries on the table in the here and now.
There are ways to combat this, as I’ll discuss next week. But it takes a great deal of discipline to stay balanced and it takes a full understanding of long-term goals and visions to know you’re heading in the right direction. It’d be very easy to say we have loads of “income” and move our lifestyle to match that level of income. But by doing that, our bank account would drain and drain and drain.
Keep an eye on your deferred income sources and your cash flows. Live to your cash flows, not to your deferred income levels.
As always, I appreciate you making it this far. This topic is near and dear to my heart, because it presents a need for balance and discipline unlike most other types of financial experiences. I am quite excited to do some writing next week about how to handle liquidity issues if you have a lot of deferred income.
In the meantime, have a safe, healthy, and prosperous week ahead.
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