What do you think about wealth? – Defining Wealth by Income, Net Worth & Lifestyle (P1)

What do you think about wealth? – Defining Wealth by Income, Net Worth & Lifestyle (P1)

If you pick any 10 people at random off the street and ask them all whether they’d like to be rich, chances are all 10 will say yes. But if you ask those same 10 people what they mean by “rich,” you’re likely to get 10 different answers.

One person, perhaps, would say that a million dollars is enough to make you rich, while another would say that it takes 10 million. Still others would give answers that weren’t expressed in dollar terms at all. They’d say that wealth means having a big house, a boat, and a private jet – or maybe just a comfortable home and good health insurance.

But the truth is, we don’t all know what “rich” means, because it means different things to different people. And if becoming wealthy is one of your personal financial goals, it’s important to think about exactly what wealth means to you. You need to have a clear idea of what your dream of wealth looks like – what kind of rich person you want to be – before you can come up with a plan to make that dream a reality.

Wealth as Income

When Americans talk about being wealthy, they often focus on having a high income. For example, during the Occupy Wall Street demonstrations, protesters adopted the rallying cry, “We are the 99%” – setting themselves aside from the top 1% of earners who, according to the Economic Policy Institute (EPI), brought home an average of $1.3 million in 2012. That’s nearly 30 times as much as the average income of the remaining 99% of Americans, so branding this group as outrageously rich doesn’t seem, at first, like much of a stretch.

However, there are a few problems with this definition of wealth. First of all, the average income for the top 1% is skewed upward by the even smaller percentage who make extremely high incomes, amounting to tens of millions per year. The income threshold for the top 1% – the amount of income you need to make to be part of this group – is a much lower $385,195, according to the EPI.

Admittedly, that’s still quite a lot compared to the $43,713 that’s the average income for the rest of the American population. However, this figure is for the entire country – in specific states, the earnings of the top 1% can be much higher or much lower. In Arkansas, for instance, anyone with an income of more than $228,298 is part of the state’s top 1%, while in Connecticut, the cutoff is $677,608.

This goes a long way toward explaining why you see many arguments regarding how much income it takes to be really rich. For instance, in 2010, when President Obama proposed raising taxes on families with incomes greater than $250,000, The Fiscal Times argued that in many parts of the country, a family of four would actually have a hard time making ends meet on that income. Between taxes, housing, food, transportation, childcare and education costs, and other incidentals, the family would never be able to afford luxuries like private schools, a vacation home, a country club membership, or designer clothes – in other words, the lifestyle that most people associate with the word “rich.” Eventually, the president and Congress settled on a deal that raised taxes only on families with incomes greater than $450,000, effectively setting that as the new bar for what it takes to be rich in America.

However, simply adjusting the cutoff doesn’t address the biggest problem with using income to define wealth: If you have a high income and spend every penny of it, you end up with nothing at all in savings. That means that if you suddenly lose the job that’s providing you with all that income, you become broke overnight, with nothing left to live on. Being in a precarious position like this, where a single change could take you from a comfortable life to the edge of bankruptcy, isn’t most people’s idea of wealth.

High Income Spend

Wealthy investors – those with a net worth of $5 million or more – tend to agree that income isn’t the best way to define how rich a person is. In a survey of more than 1,100 such investors by Spectrem Group, only 6% of respondents defined “rich” in terms of a person’s current income. Instead, a majority said that the definition of “rich” should hinge on a person’s net worth – the total of all that person’s financial assets, minus the person’s outstanding debts.

However, while wealthy investors agree that it’s possible to define wealth in terms of a specific dollar figure, they disagree widely on just what that figure should be. When Spectrem asked investors exactly how much money it takes to make a person rich, they gave answers ranging from $1 million to more than $5 million. And other studies of investors show that even those who have achieved these levels of wealth don’t necessarily think of themselves as rich – largely because their expectations expand along with their income.

Understanding Net Worth

Economists generally agree with the investors in the Spectrem survey that net worth is the best way to define wealth. However, they emphasize that net worth isn’t just about what you own – it’s also about what you owe. To calculate your net worth, you add up all your assets – money in the bank, investments, your house, your car, and so on – and then subtract all your debts, from students loans, to unpaid back taxes.

This means that a person with a very extravagant lifestyle – a huge house, several fancy cars, designer clothes, and lavish parties – isn’t necessarily rich in terms of net worth. If the house and the cars were all paid for with hefty loans, the person’s actual equity – the amount that belongs to the so-called owner – could be quite low. It could even be negative if the house or cars have fallen in value, leaving the buyer with an upside-down loan. The closet full of designer clothes, no matter how much they cost to buy, probably isn’t a significant asset, and a big party – even a really great one – isn’t an asset at all.

By contrast, a person whose lifestyle appears to be modest can actually have a sizable net worth. The classic example is investor Warren Buffett. Although his net worth of over $60 billion makes him one of the richest people on the planet, Investopedia reports that he still lives in the same Omaha house he bought for $31,500 back in 1958. He scorns luxury cars, and he celebrated his second marriage in 2006 in a 15-minute private ceremony at his daughter’s home.