The Truth About Your Income
Just out of graduate school in 1993, I was offered two very different jobs. One was working for a large accounting firm in its bankruptcy division. This was just after the commercial real estate crash, and all the accountants, attorneys, and other such professionals had developed a specialty in bankruptcy.
The other was teaching high-level investment theory to institutional investors, primarily from Asia, for a well-respected financial consulting firm. The duties of this job were much more familiar, given I had just spent two years studying these exact concepts to get a master’s in finance.
The first job was in Dallas and the second in New York. My dream was to have a career in investments on Wall Street so that teaching job looked pretty attractive.
The only problem was that the job in Dallas paid $55,000, while the job in New York paid $35,000. That difference, however, wasn’t quite big enough to keep me from my dreams of working in the financial world in New York. So, off to the Big Apple, I went.
Money isn’t everything, as they say, and they are absolutely right.
Unfortunately, the job did not turn out to be as advertised, and I was soon on the hunt again.
From there, I found a job managing money for small, rural banks in Texas (quite a change from the hustle and bustle of NYC!), and that’s where my true love for the investing world flourished. It took me two more years before my pay overtook that initial $55,000 offer from the accounting firm, but I couldn’t be happier or more motivated to do well by my clients.
By the mid-1990s, bonuses had started to become common in the financial world, and for many years, my bonuses were about 10-20% of my salary. When my career brought me to the Bay Area in 1995, and to a more forward-thinking investment firm, the bonuses awarded to me crept up to 40 and then 50% of my salary – Woah!
The firm I worked for at the time had no stock to offer, which is somewhat of a detriment in the Bay Area. This was because it was a small, closely-held boutique firm – but they compensated by paying higher bonuses, which increased to and beyond 100% of salary in the growth days. Double Woah!
In the early 2000s, I went to work for a regional bank that focused on the tech industry. Many there saw themselves as frustrated tech entrepreneurs and, therefore, similarly structured their compensation.
At that time, I was receiving a bonus that was about 30 – 40% of my salary, and stock in the form of both stock options and restricted stock units.
Stock is a peculiar thing in that it is awarded at today’s value, but you don’t get it today – you get it at some point in the future. And when that future comes, the price of the stock then determines the actual value you receive.
There were times when I was awarded stock at X dollars, but by the time I could access it, I had two or three times as much money as the initial award. And of course, there were other times when I experienced the downside of these awards, too, when my company’s stock fell from $56 per share to $16 per share.
Such is the risk with stock compensation.
Now, I know I shared a lot about my own personal compensation journey, but that’s because I wanted to highlight a few points. When it comes to your income, there are a few things to keep in mind:
- We can control or at least influence the amount of income we receive.
- Income is undiversified, meaning any number of things can happen to make it grow, decrease, or go away completely.
- Income is not something we own until we actually receive it – we have no rights to future payments until the time comes.
- Because of all of the above, income requires our focus and our effort to achieve it.
You may have noticed that I excluded income from investments here. To receive such income, you must give up a large chunk of your investment today. Are you still with me? Say, for example, you put $100,000 into an investment with the expectation of receiving $5,000 per year. You don’t earn any “income” for the first 20 years. You are merely getting your money back. I don’t consider this to be “income.” This is a topic of its own, and I will expand on this viewpoint in a future blog post, but for right now, let’s continue!
Further, we need to understand what is important about our income, other than just the amount. And those two things are:
- Timing– When we are awarded income vs. when we actually receive and can use it.
- Taxes– Whether the income hits before or after taxes.
Who knew there was so much to understand about income, right? It’s important to remember the points I’ve shared above as we move forward in our discussion to understand the types of income we might have. All of this will lay the foundation to help you build a plan that uses your income in the best way possible.
What is Income?
There is an increasing number of ways to be compensated for what we do, and it’s key to know how you are being paid, when, and why. Let’s take a look at the most common types of compensation.
1. Salary– Your salary is, of course, the most common form and is a fixed, regular payment that comes either twice a month or every other week. Your deductions are taken primarily from salary in the form of taxes, retirement savings, fringe benefit awards and purchases, and additional savings (such as Employee Stock Purchase Plans).
2. Vested Stock– Here, we only want to consider stock awards that have already vested. If you are let go or if you decide to leave a job, your unvested stock most usually goes away, so we don’t want to count that as compensation yet. Within vested stock, there are many different flavors:
- Restricted Stock Units (RSUs) – These are special shares of stock that are awarded directly from the company – they don’t come from the traded market. Once you sell them, they become freely traded shares that anyone can buy, but until then, they are segregated and may even have a different share price and structure than the publicly traded stock.
- Non-Qualified Stock Options (NQSOs) – These stock options are very different from stock. They have a “strike” or “exercise” price, which you can think of as a fixed price that you can purchase company stock for. So, if your strike price is $40 and the actual stock is trading at $65, you can buy it, immediately sell it, and pocket $25. The value of this option is, therefore, $25. However, if the value of the stock is $35, the value of your option is $0. Stock options can fuel a lot of growth, but it comes at the risk of taking home nothing.
- Incentive Stock Options (ISOs) – This particular form of stock option has a tax advantage over NQSOs, but you have to make the right decisions on the timing of exercise and sale of the award. ISOs are less common today and are typically only given to the highest of executives due to accounting changes that make them more expensive for your employer to issue.
- Employee Stock Purchase Plan (ESPP) – Your ESPP is not, strictly speaking, a source of income, but it can be seen as “free money” if you participate in the right way. Each company’s plan is different, but the basics are that you set aside some portion of your paycheck to buy your company’s stock at a discounted price. There is typically a lag between the payroll deduction and stock purchase. Still, once the stock is purchased at below market price, you are typically free to sell it immediately, creating extra income vs. not participating in the plan.
3. Social Security – This income is derived from your payroll deductions throughout your working life, and some may not consider this actual income. However, since there is no guarantee or even correlation between the payments you make during your working years and the payments you receive, I prefer to think of the deductions as expenses and the checks received as income. Determining when and how to file for social security can mean the difference of tens of thousands of dollars over your lifetime.
For most people, these are the only sources of income they will receive.
So, What’s Not Income?
Truth be told, it’s easy to confuse specific cash flows or even promised cash flows as income when they are not. Below are a few examples. Note: beware of investment salespeople who seem to invent such “income streams” regularly.
1. Investment Income– Investment income is simply the return of something that was already yours. Let’s take a closer look.
- Dividends– When a company pays a dividend, the money comes from the company itself. Therefore, the value of the company stock must decline by the amount of the dividend. If a stock is worth $40 immediately before paying a dividend of $1, the value of the stock must drop to $39 after paying the dividend. This is hard to see in actual share prices because there are so many moving parts, but understanding that the money comes from the company is crucial to understanding this concept. The bottom line, a dividend is a return on something you already own.
- Properties– Similarly, when a renter of your property pays you, you are receiving part of the value of your investment. If you sell the property to another investor right before rent is due, the value of your property includes that incoming rent check and the expectation of all rent checks in the future. Therefore, the payment received is part of the value of the underlying investment.
- Annuities– We touched on this above, but if you pay $100,000 to receive a stream of “income” of $5,000 per year, is that first payment truly income? Or, does it simply replace part of the initial cash outflow you just experienced? I argue that for the first 20 years, you are only receiving back your initial payment and the income really starts in year 21.
2. Deferred Income– Many companies allow you to defer part of your paycheck to future years. In the meantime, they will index the value of that deferral to an interest rate or the stock market. However, it is important to realize there is no actual account with an investment in it. Instead, the company is tracking the value and only promises to pay you the resulting amount in the future. This means you have received no income at this point, only a promise from your company. If the company hits tough financial times, you will stand in line to be paid like anyone else who lent them money. Simply put, you are making a loan to your employer through a payroll deduction. Deferred income is not actually income until it is paid out to you, which can be up to 10 years after you have deferred it.
- Unvested Stock – Another topic we touched on above, unvested stock is not actual income YET. When listing your assets, be sure not to include unvested stock awards.
- Inheritance– Any inheritance, expected in the future, should not be counted on for future expenses. Not only may beneficiaries change, but life has a funny way of getting very expensive toward the end. The folks you believe to be leaving you money when they pass may need it for themselves.
What Gets in the Way?
At first glance, income seems like such a simple concept, right? After discussing all the different types, what counts as income, and what doesn’t, it’s easy to see how truly understanding income can get complicated quickly.
We all have some level of control or influence on our income throughout our lives, but we don’t have complete control. Life can happen to us at any time, causing adjustments that not only affect us today but can affect our ability to do everything we want throughout our lives.
It’s also important to remember how timing and tax impact various types of income. With some, there are decisions to be made that affect how much income we receive after tax, as well as the timing, which needs to fit our financial plan.
With all this in mind, here are a few tips to keep in mind and get you started on your quest to understanding YOUR income.
Pro-tip #1: Make an inventory of the types of income you receive so you can understand the various types of challenges associated with each.
Pro-tip #2: Create a strategy for each income stream so that you are taking advantage of the tax and timing benefits while avoiding any pitfalls.
Pro-tip #3: Understand what is NOT income. This will help us avoid the tricks and traps that many on Wall Street set for us. Knowing the difference between the return on our investment and true additional cash flows (income) is crucial to understanding what is being pedaled by the high finance types.
Here’s the Good News
So, how do you feel? Like you have a better grasp of what income truly means? I hope so. You see, with the knowledge above, we are better armed to take advantage of opportunities as they arise. In particular, understanding the difference between simple cash flow and actual income allows us to evaluate money decisions better.
We can adjust and grow with change. No one ever had a life that went according to plan. Still, when challenges arise, we can create opportunities for ourselves as long as we maintain an understanding of what truly creates financial growth for us and what simply transfers our wealth to others.
Now that you know your income sources and how to differentiate them, you can better understand what might be possible for you, financially, in the future.