“Money is only a tool. It will take you wherever you wish, but it will not replace you as the driver.” ~Ayn Rand
Every year around this time I become keenly aware of the reality that TAXES are indeed one of, if not the biggest drag on my financial life. They cast potentially a lot of money, and for this reason cause a lot of stress. Indeed, I like to get my tax paperwork in to the IRS as quickly as possible just to know that it’s done, and thus every year in the first days of January my QuickBooks files go to my CPA…
Even though I am not a CPA and far from having the knowledge of a CPA, for one reason or another friends approach me for perspective when it comes to money and taxes. Since my experience tells me that by and large people ask for advice in order NOT to follow it, I tend not to dig into any specifics. However, I do take the time to paint the big picture when asked:
ALL INCOME IS NOT CREATED EQUAL
As I see it, the Internal Revenue Service defines in very clear yet subtle terms exactly how to pay less taxes. In order to understand how to pay less taxes you must first realize that there are different types of income, and that they are treated by the Internal Revenue Code very differently indeed. The Internal Revenue Service groups all income into three broad categories: Earned Income, Passive Income, and Portfolio Income. While passive and portfolio are income is generated via investments, earned income is either employment (W2) or self-employment (1099) income.
Most of us live in the world of Earned Income, which is to say that the vast majority of us generate income in exchange for our labor and/or services. Simply put, earned income is what you get paid by working at a job as either an employee or an independent contractor. If you are an employee, your earned income comes to you in the form of paycheck, usually at regular intervals like weekly or bi-weekly and in set amount. In this arrangement, the majority of taxes have already been taken out of your check by the time you receive it.
This works a little differently for those who are self-employed, like contractors or freelance musicians. First of all, while employees count on regular paychecks from their employers, self-employed earners often experience significant variances in their paydays depending on the terms negotiated with their customers and their ability to find work in the first place. Also, a contractor may do a room addition and two roof replacements during one month, earning him $25,000, but have no significant business during the next three months. This reality requires that self-employed people become good money managers. Furthermore, in the world of the self-employed no one withholds taxes from our paychecks on our behalf. It is our responsibility to figure out who and what we money for, and to file the proper returns with the IRS.
However, regardless of whether you are self-employed or an employee at a company, your income most likely falls under the category of earned income, because you literally had to earn it with your labor!
PASSIVE INCOME – THE MAGIC WALLET
In direct opposition to the idea that you have to be employed in order to earn income, is the notion of passive income. The concept of earning income without work is quite difficult for most of us to comprehend since we’ve all been conditioned by our parents and teachers that we must “work hard” in order to achieve. What they didn’t tell us is that by working smart, we can greatly diminish the amount of effort required to achieve our goals.
The Internal Revenue Service defines passive income as income from “trade or business activities in which you do not materially participate…” If it seems to you that this definition implies a possibility of earning income without working for it – without your material participation, you are right! This is, in fact, the implication.
I like to illustrate passive income in the following way. Imagine you have a wallet with $3,000 in it. On the first day of the month you open your wallet and take out $3,000 to spend on whatever you wish, leaving the wallet completely empty. But by the first of the next month another $3,000 magically appears inside the wallet, ready to be spent all over again. I call this metaphor The Magic Wallet, and it is my financial goal in life. Now, if you want to have a little fun, try imagining $20,000 instead of $3,000. Welcome to the life of the financially free!
Don’t misunderstand me. I am not at all suggesting that you shouldn’t work hard. I simply want to draw a distinction between working hard at trading dollars for hours, verses working hard at educating yourself how to work smart!
Some examples of passive income are rents from real estate, business income (which does not require the owner’s direct involvement), royalties from a patent or a book, pension income, etc.
Portfolio income is income resulting from paper investments like capital gains, dividend, and interest income that you might receive from ownership of stocks and bonds.
HOW TO PAY LESS TAXES
As I mentioned previously, the IRS tax code treats the three types of income very differently. Earned income is the highest taxed income of the three. With the current individual tax rates ranging from 10% to 39.6%, the tax bill can really add up quickly. In addition, earned income is subject to other taxes, such as Social Security, and Medicare which add up to 15.3%. What’s more, while a W2 employee benefits from their employer paying half of these taxes, the self-employed earner pays the entire 15%.
Portfolio income, at least as it relates to dividends, interest, and capital gains resulting from the sale of investments held for longer than twelve months, is currently taxed at no more than 20%. Furthermore, this type of income is not subject to Social Security and Medicare taxes.
Passive income from investment activities such as rental of real property is taxed as ordinary income at whatever tax bracket is appropriate, but because of the various paper losses it ends up carrying the least tax burden of the three. It is not uncommon for an investor to pay only a 10% to 15% effective tax rate, or even less. A lot of this is due to something we call Depreciation, which I discussed in another article. Additionally, there is actually a legal way to defer paying Capital Gains tax upon sale of investment property – 1031 Tax deferred Exchange, which I will discuss in a follow-up article.
BY THE NUMBERS
Let us consider this in terms of numbers. Suppose this year you earn $150,000. If you’ve earned it as an employee, then you will likely loose close to 50% of it to taxes, leaving you with $75,000 of spendable income. If, however, you earn this money by way of Capital Gains, then you will only lose 20% of it to taxes, leaving you with $120,000 of spendable income – $55,000 more. Finally, if you earn this money by way of Cash Flow from rental property, then chances are good that you’ll be able to do even better than 20% effective tax rate. So -which is better…?
Here is another way of thinking about this. Suppose you’ve decided that you need to net $75,000 per year in order to maintain your lifestyle. If you decide to achieve this goal by way of earned income, you will need to gross $150,000 so that after you pay taxes there is $75,000 left for you to live on. However, you will only need to generate $93,750, or less, of investment income in order to net the same amount. (Note – these numbers are for example purposes only. Consult your CPA professional.)
There are two questions you must ask yourself around this. First, if you are going to be able to earn $150,000 this year, would you rather lose $75,000 of it to taxes or $30,000? Or, if $75,000 is what you need to live on, do you think that you would have an easier time getting there by way of $150,000 of earned income or $93,750 of investment income? I’ll give you a clue: Both require knowledge, but it’s very different types of knowledge. In my opinion, it is considerably easier to acquire the type of knowledge which would allow you to generate investment income rather than earned income. Information is readily available and no college degree is necessary!
The reality that investment income is taxed at a much lower level than earned income tells me, and should tell you if you pay attention, that our politicians would like to incentivize us to become investors. Furthermore, the very kind treatment of income resulting from long-term investments in real estate would suggest that some very important people in Washington DC very much value our contribution to the economy…
It may not be what you want to hear, but this should answer the question of how to pay less taxes – become a landlord!