If you’ve spent any time learning the U.S. tax code, you’ve learned that taxes are due when you earn income. If you never sell assets, that’s a lot less income to report on your 1040.
That’s how some of the wealthiest Americans get away with paying a very small percentage of their net worth in taxes. Income is taxed; assets, for the most part, are not.
You may not be a billionaire. You might not yet be a millionaire. That doesn’t mean you can’t emulate some of their strategies to keep your taxes relatively low.
Yes, some changes to the tax code are on the horizon, but I’m confident that the advice below will continue to work well in 2022 and beyond. This Friday Feature from Sam Dogen was a popular post from a recent Sunday Best and was originally published on Financial Samurai.
ProPublica published an article highlighting how 25 of the wealthiest Americans paid a tiny fraction of their wealth in taxes. This makes sense because the type of tax that is often discussed is levied on income, not wealth. If you pay yourself a low income and never sell assets, then your tax bill won’t be high relative to your wealth.
According to Forbes, 25 of the wealthiest Americans saw their net worth rise a collective $401 billion from 2014 to 2018. They paid a total of $13.6 billion in federal income taxes in those five years based on IRS data. However, $13.6 billion only amounts to a “true tax rate” of only 3.4%.
The article goes on to say Warren Buffet is a hypocrite for encouraging the rich to pay more taxes. Yet he only paid a true tax rate of 0.1% of the wealth he garnered over the 4-year period. We all know that actions speak louder than words. Given Warren is an ultra-capitalist, his actions shouldn’t come as a surprise.
Let’s Follow Billionaires In Order To Pay Less In Taxes
Instead of getting upset at billionaires for paying a small percentage of their wealth gains in taxes, let’s join them. It’s the same idea as investing with an institutional real estate investor if you’re worried they’ll make the homes you want to buy less affordable.
Complaining why something isn’t fair when you can follow a similar path doesn’t get you anywhere. Neither does waiting for the government to pass legislation to try and equalize things. At the end of the day, we must act rationally and immediately if we want to build more wealth.
Below is a chart that shows how there’s a tight correlation between how much a typical American household makes and the amount of tax it pays. The chart should encourage you to be more like an owner of assets and less like a typical laboring American.
The gist of how billionaires pay less in taxes:
1) Pay yourself a token salary. For example, some CEOs pay themselves a token $1 salary. The rest of their compensation is in the form of stock grants or an existing ownership stake if they started the company. Jeff Bezos supposedly pays himself an $80,000 annual salary, which puts his income at a reasonable 22% marginal federal income tax rate.
2) Never sell any assets that would trigger a tax event. Let’s say Bezos owns 10% of Amazon. So long as the stock doesn’t pay a dividend and he never sells stock, he won’t have to pay any taxes. Even if the stock goes up another 1,000%, he won’t owe any capital gains tax.
3) Borrow money against your assets. Let’s say you own $10 billion in Google stock. You could easily sell $1 billion of Google stock to buy a $500 million mega yacht and pay about $500 million in total capital gains tax. However, it would be more tax-efficient to borrow $500 million at a low interest rate to buy the yacht.
Plenty of banks will take a bet on you and use your stock as collateral. Even paying a 5% interest rate on $500 million is much cheaper than paying hundreds of millions in tax. Further, if you’re bullish on the stock, you get to participate in any potential upside.
4) Borrow from another bank to pay off your other loan. Let’s say your $10 billion in Google stock has grown to $12 billion a year later. At the same time, interest rates have declined. This is what has happened for many investors during the pandemic.
You can simply go to another bank to borrow $500+ million to pay off your previous loan. If you can get an interest rate of 2%, you’ll have cut your interest payments in half. Further, you might find a way to deduct the interest. For example, say the mega yacht is for your mega yacht business.
Operate Like A Mini-Billionaire
Unfortunately, most Americans earn most of their income through a day job. Further, most Americans are not CEOs with massive equity stakes that can be used as collateral. However, all of us can certainly try to operate like a mini-billionaire to pay less in taxes.
Let’s use various examples where we commoners can earn income more tax-efficiently.
1) Become A Rental Property Owner
The rental property owner gets to collect rental income and deduct all operating expenses associated with managing the rental. These expenses include mortgage interest, property taxes, insurance, advertising, maintenance, and transportation. In addition, a rental property owner gets to deduct a non-cash depreciation expense.
In the example above, we have a rental property building valued at $633,308 taking a $23,000 annual depreciation expense for the next 27.5 years. If you own 10 properties each with $23,000 in annual depreciation expense, that’s similar to earning $230,000 a year tax-free.
When it comes to owning rental property, a good goal is to own it until your depreciation allowance runs out. But then you’d have to pay a depreciation recapture when you sell. Therefore, you might as well follow the billionaire’s mantra of never sell assets.
Building a rental property portfolio is one of the best ways to build passive income for financial independence. You have a relatively stable asset that generates stable cash flow. Your rental properties can provide you and your family shelter if needed. Finally, your rental property portfolio can be managed by your children one day, if you have any.
Ever since 2003, I’ve been focused on growing a rental property portfolio to fund my retirement. It was my main way to diversify away from equities, given that was my profession.
Unfortunately, I couldn’t hold onto a key property in 2017 due to constantly rowdy tenants and my desire to focus on my newborn son. However,, I did end up reinvesting 100% of the proceeds, which have all risen in value.
2) Own A Small Business
Owning a small business provides for great tax flexibility. For example, you can start an S-Corp and pay yourself a low salary to minimize your FICA tax bill. However, be careful not to pay an unreasonably low salary.
If your business is having a great year, you can decide to boost capital expenditure to reduce taxable income. Alternatively, if your business is having a bad year, you can delay capital expenditure or try and bring revenue forward to smooth out revenue. Or, you could smartly apply for a government forgivable loan, like PPP 1 and PPP 2 to get free money.
To reduce taxable income, you can have awesome quarterly board meetings in Hawaii. There’s no requirement to have them in your windowless basement.
The to and from Hawaii air tickets, meals, and accommodations are all deductible if your sole purpose is business. If you want to do a team-building event on a luxury catamaran and then eat a buffet of the finest toro sashimi, that’s probably deductible as well.
As an employer and employee, you also get to contribute up to $19,500 to your Solo 401K + 20% of operating profits. If you have the operating profit, the maximum 401(k) contribution is $58,000 for 2021. The combined maximum should go up every couple of years.
In the below example, the business owner contributes $18,000 + $13,000 = $31,000 in a Solo 401(k) that doesn’t get taxed. In addition, the business owner contributes another $10,000 to two traditional IRAs. Instead of paying taxes on $90,000 in gross profits, the owners pay taxes on a much lower income.
My wife and I are technically small business owners. We own 100% of Financial Samurai and will likely never sell for liquidity reasons. Selling would trigger a vomit-inducing tax event that creates economic waste. We should have enough ongoing investment income to pay for our living expenses indefinitely.
If we need cash for some reason, we could put up the equity in our business as collateral just like Jeff Bezos. But unlike Jeff, we can’t borrow hundreds of millions to buy a mega yacht. Maybe we could buy a remote control boat for our little one instead.
3) Retire Early Or Give Up Maximum Money
No longer making a W2 income is one great way of paying less in taxes. You’ll only have to pay taxes on your dividend income and capital gains. If you decide to never sell assets, your “true tax rate” as ProPublica calls it will also be a tiny portion of your growing net worth in a bull market.
You could also give up making maximum money for a lower-paying job. Once you start making over ~$210,000 as an individual or ~$420,000 as a couple, you start paying an uncomfortably high federal income tax rate of 35%. If you also have to pay state income tax, your combined marginal income tax rate plus FICA tax will easily bring you over 40%.
The standard deduction limit this year is $12,550 per individual or $25,100 per couple in 2021. Therefore, you could earn as much as these limits and pay zero income tax. For all you students out there, it’s time to make some tax-free money and fund your Roth IRAs!
Further, if you are fortunate or unfortunate enough to have a household income of well over $400,000, you will likely have to pay a top federal marginal income tax rate of 39.7% if President Biden gets his way.
Once you get close to paying 50% of your marginal income over a certain amount to the government, it doesn’t make sense to try and work so hard to make more.I’ve argued that earning $300,000 – $350,000 a year is good enough for a family of four in the highest-cost areas of the country. Earning more is completely unnecessary if you are not happy at your job.
Find A Different Way To Make Money
Earning W2 income is the worst way to earn because it faces an ordinary income tax rate that is higher than the investment income tax rate. Therefore, focus on earning investment income to pay a lower tax rate. Just don’t make too much either because the top capital gains tax rate might go up as well.
The main lesson we can learn from billionaires is to change the composition of our earnings. The next important lesson is to never sell our beloved investments. Try to hold onto them for as long as possible so they can compound over time.
If we need money, we should be able to draw from our passive income streams. And if we need even more money, it’s better to take out a loan, especially with interest rates so low. For many, a HELOC is a common source of funds.
If I were you, I’d focus on making more rental income, business income, and dividend income to pay less in taxes. Try and completely replace your day job income. If you do, you’ll find that you really only need 80% – 90% of your day job income in the form of investment income thanks to it getting taxed at a lower rate.
Taxes Will Eventually Be Paid By The Rich
Billionaires and other executives will eventually have to pay a boatload of taxes if they get stock grants. They will either pay ordinary income tax on the award when it’s granted and pay long-term capital gains taxes on the gain when they sell. Or they can pay ordinary income tax on the whole amount when it vests.
Upon death, the ultra wealthy will have to pay massive estate taxes as well. So don’t worry! Billionaires and other extremely wealthy people pay plenty of taxes too. They just do so in a more efficient manner while living. Before dying, hopefully they give most of their wealth away to a surviving charitable organization that will be more efficient than the government at spending their money.
Finally, if you are really jealous of billionaires paying a relatively small percentage of their wealth in taxes, buy their stock! Clearly, these smart people with unlimited resources know better than most. Therefore, why not join them in their wealth extravaganza bonanza?
Readers, what else can we learn from billionaires in order to pay less in taxes? Why are people comparing a person’s tax bill with their net worth growth instead of income earned? Is a wealth tax the right move? What else can we learn from billionaires besides reducing our tax liability? Disclaimer: Always check with a tax professional before making any tax moves.
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