John F. Kennedy once said, “Ask not what your country can do for you, ask what you can do for your country.”
I took his message to heart when I came to America as a teenager. As soon as I started my first job out of college, I was proud to pay taxes to help our country thrive.
Starting around age 26, I began paying more than $100,000 in Federal and State income taxes a year. I distinctly remember coming home after a 14-hour day exhausted and finally analyzing my pay stub.
25 percent of my pay went to Federal taxes. 6 percent went to State taxes. 7.65% went to FICA taxes. After contributing to my 401(k), more than half my gross paycheck was gone.
It’s one thing to pay taxes when you’ve got a pleasant job with relatively comfortable hours. It’s another thing to pay lots of taxes when you’re often miserable at work. The desire to be so patriotic like JFK said declines.
Making W2 income is the most inefficient way to earn money. High taxes is why some CEOs gladly accept a $1 salary in exchange for earning stock grants that are taxed at long-term capital gains tax rates.
Let’s look at my three favorite ways to earn money and pay less taxes.
How To Earn More And Pay Less Taxes
One of the easiest ways to pay zero income taxes is to make your income equal to your standard deduction.
Single filers get a standard deduction of $12,200 while married couples get a standard deduction of $24,400 for 2019. The standard deduction should continue to inch up over the years to keep up with inflation.
Unfortunately, not many adults can comfortably live off $12,200 a year. In fact, the Federal Poverty Level (FPL) is $12,140 for one person and $16,460 for a two-person household.
Besides making less money, we all know about the benefits of an HSA plan, contributing to a 401(k), IRA, Roth IRA (not a fan for higher income earners), and opening up a 529 plan for your kid. Letting your investments compound tax-deferred or tax-free is wonderful.
Let’s talk about bigger picture ways to pay less taxes that may also provide you a better lifestyle today. After all, we might not live until the age when we can withdraw funds penalty-free from our pre-tax retirement accounts.
1) Generate More Qualified Dividends And Long-Term Capital Gains
Generating more qualified dividend income and long-term capital gains is highly tax advantageous compared to earning more W2 income.
Qualified dividends are those paid by domestic or qualifying foreign companies that have been held for at least 61 days out of the 121-day period beginning 60 days prior to the ex-dividend date.
Long-term capital gains is generated by holding and selling any asset for more than a year.
As you can see from the chart below, once you start making over ~$38,701 as an individual, you get to pay a lower long-term capital gains tax rate (15%) than your marginal Federal income tax rate of 22%. If you make less than ~$38,601 you pay a 0% long-term capital gains tax rate.
Impressively, you can actually earn up to around $425,800 a year as an individual in long-term capital gains and still only pay a 15% tax rate. Even if you make multi-millions in long-term investment income, your maximum tax rate is capped at 20%.
But let’s not forget the 3.8% Net Investment Income Tax (NIIT) on income over $200,000 for singles and $250,000 for married couples to help pay for more government waste.
It’s logical that long-term capital gains tax rates are lower than Federal income tax rates since the income used to build an after-tax portfolio was already taxed.
The larger you can build your after-tax investment portfolio, the more passive income you will generate. The more passive income you can generate, the more options you will have to become financially free.
Remember, your goal is to try and live your best life now, not when you’re too old to move.
2) Own Rental Property
Owning a rental property is like owning a business. All expenses related to running your rental property are deductible from the rental income. Just be careful and remember that deductions start phasing out after you make over a certain income amount.
A key rental property expense is depreciation. Depreciation is a non-cash expense to provide a fair way for the normal depreciation of your property.
There’s no escaping property tax, but at least it’s a deductible expense. While owning your property, it’s worth trying to convince your property assessor that your property is worth as little as possible.
One of the good things about owning rental property is that you usually acquire rental property during your higher income tax bracket years. But rental income is generally the lowest during the early years of ownership, hence the lack of taxable rental income.
Once you’ve retired, you’ll probably be in a lower tax bracket and should receive more rental income given your rent will be higher and mortgage interest and amortization will be lower. In other words, rental income becomes more meaningful as you get older, which is exactly what you want.
The only thing about owning rental property is that it scores low on the passive investing scale. The older and richer you get, the less you want to deal with maintenance and tenants. This is where investing in real estate crowdfunding and REITs come in if you continue to want real estate exposure without the hassle.
Finally, you’re always free to “house hop” by buying a fixer, renovating it, living in it for at least two out of the past five years, and then flipping it for a tax-free profit up to $250,000 as an individual or $500,000 as a married couple.
Just know that you might have to prorate the tax-free profit if you make the house a long-term rental.
3) Earn Business Income
Starting your own successful business is harder than just working a day job, but it’s one of the most gratifying things you can ever do once you gain inertia.
A lot of your normal living expenses can be considered business expenses. For example, you can have annual board meetings in Hawaii if you want. The flights and accommodations are deductible. Nobody says your annual board meeting has to be held in a place of suffering.
You can also deduct your cell phone bill, laptop, car lease payments, and a bunch of other common things that are required to operate your business.
Before you start a business, you must at least start your own website in this day and age. Over three billion people are online and this figure is only going to grow over time.
In the above example, your cupcake business generates $100,000 in revenue and $90,000 in gross profits after paying for the ingredients used to make the cupcakes.
$25,000 for normal operating expenses leaves you with an operating profit of $65,000. For simplicity’s sake, I’ve equated $65,000 as one part salary and another part distribution.
Since you want to reduce your taxes, you contribute $31,000 to your Solo 401(k) and $10,000 to two IRAs. Your business’s taxable income falls to just $24,000.
Depending on how you structure your business and earnings, you might be able to deduct additional items from your taxable income or salary. The chart above is just a simple illustration.
You want to incorporate as a C-Corp, LLC, or S-Corp. For most small businesses, I like incorporating as an S-Corp as there may be tax benefits in the way you pay yourself a salary and distributions.
Once you start making an operating profit above ~$200,000, the S-Corp loses its benefit in my opinion because the maximum income for FICA tax is $132,900 for 2019. You don’t want to pay yourself much more in distributions than salary to minimize chances of an audit.
Also beware the IRS has an eye for businesses that are perpetually loss-making. They know there are unscrupulous people out there who establish a business for the sole purpose of shielding their income. After several years, your business should start earning a profit or else.
How A Big Business Pays Less Taxes
Before media company Gawker Global went bankrupt, we learned it had set up a Hungarian subsidiary to help the parent company drastically lower its tax bill. As a result, Gawker Global was paying an effective tax rate of ~4.5% versus a ~30.6% effective tax rate had it not created the subsidiary.
Check out the chart I created below to help illustrate how Gawker Global paid less taxes.
The chart shows the US company earned $1,000,000 in advertising revenue in one year. But because it hired its own Hungarian subsidiary and paid $1,000,000 for editorial, website, and design work, the US company claimed no profit and therefore pays zero taxes.
Meanwhile, the Hungarian subsidiary earned $1,000,000 in revenue and deducted $100,000 in labor expenses of its own for a $900,000 operating profit. Because Hungary only has a 5% corporate tax rate, it only has to pay $45,000 in taxes.
Instead of Gawker Global paying $306,000 in taxes, it ends up paying only $45,000 in taxes. Now that’s what I call tax-arbitrage!
I’ve yet to understand how Amazon was able to pay zero income taxes in 2018 on profits over $11 billion. That is a truly amazing feat that partially shows why Jeff Bezos is one of the richest people in the world.
He must be thinking to himself, only the little people pay taxes!
Reconsider Your Day Job Income
If you are a W2 income earner, the only things you can do to reduce your tax liability are max out your pre-tax retirement accounts, contribute to your HSA if eligible, and see if you can defer bonus income to a potentially lower income year.
Consider earning qualified dividend income, long-term capital gains, rental income, and business income instead. Not only are such income sources more tax efficient, but they might also provide you with a better lifestyle.
Although I still pay over $100,000 in Federal and State income taxes a year, my effective tax rate is lower than while I had a full-time job. Further, I’m having a lot more fun running a lifestyle business than grinding away in the banking world. My patriotism runs high!
At the end of the day, if it means making more money, it’s better to pay more taxes than less taxes. But eventually, there’s a law of diminishing returns where you’ll no longer want to work as hard if your marginal tax rate gets too high.
That day might be coming sooner than we think.
Readers, what are other great ways to earn income that hasn’t been mentioned in this article? Tax professionals, feel free to share your thoughts on our complicated tax system.
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