The Cashflow Quadrant – Why The Rich Get Richer

Robert Kiyosaki’s books have a lot of junk in them. As I’ve mentioned in my review of Rich Dad Poor Dad, his books are thought provoking and go against the grain of many other personal finance “gurus”, but they contain a lot of fluff. The signal to noise ratio in his books are pretty high. However, there are some gems to be found. One of my goals with this blog is discussing what I think are some of the good ideas in the financial space. One of Robert’s great concepts is the CASHFLOW Quadrant ®.

It explains the various career paths and clearly explains our tax system structure. After reading many financial books over the years, I don’t accept anything discussed as gospel. I take in the good ideas, see what works, and throw away the bad ones. If you were to take in only one of his ideas, this would be it. Love or hate Robert, his Cashflow Quadrant makes sense. It explains perfectly the way our tax system has been setup and how various professionals view the world.

As Kiyosaki discusses in the book “The Cashflow Quadrant” a table is divided into four areas. E and S quadrants are on the left side, and B and I quadrants on the right side. The diagram below better explains it. You can be in all quadrants, but most people are not. The goal is to progress through the arrows and become more on the right side of the table.

  • E Employee (E) – Otherwise known as a job
  • Self-Employed (S) – Small business owners or self employed (Doctors, and lawyers)
  • Business Owner (B) – Big businesses (500 and more employees). Businesses that are selling products and predefined services.
  • Investor (I) – People like Warren Buffett

Active Income

On the left side of the table is active income. You are trading time for money. In order to make money you must perform something. Every day you start from zero.

Passive Income

On the other side, it is passive income. You do not have to be present to generate income. Things like real estate, stocks, bonds are sources of passive income. You are literally making money while sleeping.

Cashflow Quadrant

Cashflow Quadrants

E – Employee

Most individuals only live in this area. You work for a company and trade your time for money. If you want to earn more money, you must work more hours. Another option is work for another company that pays better. With this position in the quadrant there is no passive income. If you don’t work, you don’t make any money.

S – Self Employed

This is one step better than an employee, but in reality you still are trading time for money. You own your own business, but in reality the business owns you. The positive benefit you have more personal and financial freedom than an employee.

B – Business Owner

A business implies you have a system in place. You have others working for you as employees. You aren’t selling your time for money, but rather selling a product or service. In other words, you don’t have to be working for the business to generate income.

I – Investor

This is where you truly have passive income. Investments like stocks, bonds, and real estate generate an annual cashflow. These are the investments that will allow you to retire. It can also be things like trademarks, copyrights, and royalties. Things you build once and have a long (5-10 year+) timespan in payouts.

Conclusions

At one time, small businesses were praised in our country. After all, small businesses comprise 70-80% of our economy. That, unfortunately, doesn’t seem to be the case anymore. The self-employed are constantly getting hit with new taxes that larger businesses can either avoid or minimize through various legal tax loopholes or vaivers. Small business owners don’t have lobbyists, a team of lawyers and accountants to minimize taxes and regulations.

Rightly or wrongly, our tax system is designed to favor large businesses (B) and investors (I). Typically in these quadrants you get lower tax rates. Through lobbing you are able to create a large moat around your business to prevent others from competing.

The goal then should be as to get in these two quadrants as much as possible. This isn’t making a political statement, it is just the way things are setup. Regardless which political party and system you believe in, it’s just the way the world works. What matters is the way things are, not in some ideal fantasy land. Our tax code is designed to favor investing and large businesses.

This perfectly explains Mitt Romney’s effective tax rate. It also explains why many high paid salaried employees get screwed with our tax system. It also explains why a company like General Electric (GE) paid only 2.3% in taxes in the last decade.

Readers: Which side of the cashflow quadrant are you more on?

Comments

    • says

      “Kiyosaki is such a colossal fraud that I couldn’t in good faith recommend his books to anyone.”

      W, I don’t disagree with your statement. Though that’s not the point of the post. Don’t throw the baby out with the bathwater.

      In my case I’ve owned a rental since 2001 and it’s been fine. Though I wasn’t influenced by Robert to buy a rental property.

      Do you disagree with Robert’s Cashflow Quadrant? Is this not an effective way to describe our tax structure?

      • says

        I don’t really see how it does or doesn’t reflect the tax structure. Anyone who wants to file C corp paperwork can have the “big business” tax situation. And much of investment is done in limited partnerships, which look more like “self employed” tax-wise. So I don’t get it really.

        I’d also question whether it’s a progression, or one’s better than the other. It’s also hard to separate B vs I in his notation. If I own shares (invest) in a business, am I not a (part) business owner? Maybe B is businesses where you have voting control, and I is not. But Buffett was big on voting control, so the example doesn’t fit. I’m confused.

        One of Kiyosaki’s sins is just making random stuff up that sounds good. It seems to me he’s done that here.

        • says

          Yes you can file as a C corp, but can you incorporate in a foreign country? Can you do a dutch sandwich like Google and Apple did to reduce their taxes? Can you hire lobbyists? Can you get an exemption to Obamacare like McDonald’s did? Those are advantages a big business can take advantage. A small business, even if filing as a C corp, cannot.

          “If I own shares (invest) in a business, am I not a (part) business owner? Maybe B is businesses where you have voting control, and I is not. But Buffett was big on voting control, so the example doesn’t fit. I’m confused.”

          Technically yes, To the IRS no. An active business partner is much different than a shareholder.

          I think the best way to differ between the two is do you have voting rights?

          Buffett fits both. He is a business owner AND an investor.

          • says

            I’d have to go back and look at the tax code, but I don’t remember any different treatment for the activity level of the owner.

            One of my big objections to Kiyosaki is that he over-emphasizes taxes, when it’s really about earning a profit from operations in the first place. People achieving large increases in net worth don’t succeed primarily because they pay low taxes. This whole line of thinking seems to totally obfuscate the issue. Google is profitable because of their 10%ish return on debt+equity from their operations, not whether they pay taxes in Ireland or Bermuda. Operations are the main deal, taxes are the sidehow.

            • says

              Hi W,

              “People achieving large increases in net worth don’t succeed primarily because they pay low taxes.”

              Kiyosaki or not, I disagree with that issue. Taxes is the largest expense we pay over our lifetime. While it’s true minimizing taxes does not make you rich, it does help increase your wealth faster.

              In my case I certainly minimize my taxes to what is legal for my situation. We are all obligated to do this. Though a straight salary employee (especially high earner) your options are very much limited.

              Don’t think for a minute Warren Buffett doesn’t do the same, even though he states we wants to pay more. Buffett is all about minimization of taxes. Hence why he takes such a low salary and why he holds stocks for a very long time.

              With regards to Google, they saved $3.1 B since 2007 in taxes by doing the dutch sandwich. That isn’t significant? That’s much more return back to shareholders and for other investments (ie buying Motorola).

              http://www.msnbc.msn.com/id/39784907/ns/business-us_business/t/dutch-sandwich-saves-google-billions-taxes/

              The US now has the highest corporate tax rate for businesses. The ones affected by this are small businesses, not large ones (ie Google). Their effective tax rate is much lower. Which leads us right back to the cashflow quadrant.

  1. says

    “With regards to Google, they saved $3.1 B since 2007 in taxes by doing the dutch sandwich. That isn’t significant?”

    That’s PRECISELY what I’m saying. Google’s balance sheet equity is about $60B. $57B of that was built via operations. $3B was saved via a nifty tax trick. In other words, it’s 95% operations, 5% tax stuff. Operations are the big deal. Taxes are the sideshow.

    I’m not suggesting people shouldn’t minimize their taxes. Go to town. What I’m saying is that you can’t get rich primarily by doing it. You get rich via some sort of profitable operations. You get a few % richer with tax tricks. I do think the US retained earning tax is a bit high, but mostly on the basis of regulatory competition issues, not because it’s keeping small business down. The problem with most failing/marginal small businesses is that they don’t have profitable operations at all.

    • says

      I donno maybe it’s me because I sure would love to have $3B :-) They bought Motorola for $12.5B or 1/4 of their cost. In terms of percentages of how much they have in the bank, yes it isn’t a lot, but still helps their bottom line. Their huge cashflow, and how much they have in the bank is masking the tax savings in your example. Both GOOG and AAPL are minting money like very few companies in history have done. They are many other companies who also use the dutch sandwich who aren’t as profitable. I know PFE uses it also.

      I think most companies would kill for that dollar amount in tax savings.

  2. says

    W,

    This has NOTHING to do with the post, but something I think you’d both find interesting. There are plenty of clients at my office that end up actually pass more money to their family by planning for Estate Taxes (especially when the exemption was lower and the rate higher) than they would working.

  3. says

    Actually, I think a lot of us are in the first and fourth quadrants both. WHo doesn’t have a 401K with their job?Or if you invest in an IRA, too. A lot of peopel do these things who have regular 9-5 jobs and so I’d say most people do the E and I both!

    • says

      Hi TB,

      “Who doesn’t have a 401K with their job?”

      Actually a lot! Many companies don’t offer them, and many others don’t contribute. I’m trying to find some numbers, but from memory many 20-30 year olds for example do not. With the recent economic crisis, many view the stock market as a casino.

      While Robert states he hates 401(k)s (I don’t but does depend upon the plan), that are one of the good vehicles to invest in. 401(k)s are far from perfect but they are one option to consider that puts you into the (I) quadrant.

    • says

      Here are some stats:

      http://www.sba.gov/advocacy/7540/12121

      “Almost 72 percent of workers in small companies have no retirement plan available through the company; an additional 9 percent have a company-sponsored plan available but do not participate. Only 19.5 percent of workers in small private sector companies report participating in a retirement plan.”

      Keep in mind this is just small companies, but small companies comprise 70-80% of our economy.

  4. says

    I agree with Guy selling fluff but this is actually a good concept. The question is, where do you go from here? If we all start out with the jobs and such on the poor side, how can we get to the final, passive side?

    I’m currently in three quadrants trying to move to the final quadrant. It’ll take time and lots of effort but I’d love to have a road map.

    • says

      Unless you are born with a silver spoon, I think the only way is to save, and/or create businesses that create decent cashflow. I don’t think there is any shortcuts, or easy way through the process.

  5. says

    I have bought and read Rich Dad and Cash Flow Quadrant. Although Kiyosaki has his issues, both of these books are worth the time and money to read. He is dead-on with his assesment of the tax code and it’s dealing with the various forms of income. He is also on track with the benefits of real assets.

    But, I have the same comment as Sandy. There are good concepts in these books, but not a lot of practical, actionable steps. If someone has a plan to open or invest in a business, they probably don’t need Kiyosaki to tell them it’s a good idea. If someone is looking for a business to start or invest in, they probably won’t find it in these books.

  6. Kartavi Dave says

    Its true that “There are good concepts in these books, but not a lot of practical, actionable steps.”
    I am in India and having a permanent job in Govt run Company, which is here considered as 100% secure and sufficient salary for middle-class. I am in E quadrant. Now tell me what should I do to move from E to … S or B or I ?

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