By Toby Mathis
Just about everyone wants to reduce the amount of taxes they owe the government each year, but here’s something many people don’t consider: The source of your income makes a significant difference in how much you pay – or whether you pay anything at all. And it’s not just income tax that’s at issue. There are other ways that governments – both federal and closer to home – take a whack at your money, slicing out their own portion for a variety of government needs.
The wealthiest among us figured this out long ago. Not only do they gravitate to income sources that are less susceptible to taxes, they also don’t rely on just one or two sources the way too many people do. The wealthy make sure they have money coming in from three, four, five or more sources.
But you don’t need to be among America’s richest people to begin taking advantage of many of those same income sources that the wealthy do and, as a result, pay less in taxes each year. By taking time to study where the government siphons off the most income from taxpayers, you can begin to find clues to how you can keep more of those dollars in your pocket.
I divide those potential income sources into three buckets: the bad bucket, the better bucket and the infinity bucket. The wealthy gravitate toward plucking their income from the sources in the better and infinity buckets, and you should, too.
Let me break down what I mean by each bucket and explain why some types of income are more advantageous when it comes to you and your dealings with the IRS. Then we will look at some examples of how you might put these into action with your personal financial situation.
- Bad bucket. Within this bucket lies income that’s most vulnerable to the government’s yearnings. It starts with wages. For most Americans that’s where the bulk of – or perhaps even all – income originates. Look at your pay stub and you will see deductions made for federal income taxes as well as for Social Security and Medicare. In some states, there will be withholding for a state income tax. You also may have deductions for county and city taxes, state disability or unemployment insurance. With all these deductions happening prior to you seeing your money, the amount that ultimately ends up in your bank account starts shrinking fast.
Self-employment income is another area susceptible to the government’s attention. If you’re working for yourself as a sole proprietor, you will be audited more. Also, not only do you pay income tax, but every dollar you make is subject to the self-employment tax, which is 15.3% of net earnings. That percentage breaks down to 12.4% for Social Security and 2.9% for Medicare. One difference between self-employment and working for others is that when you have an employer, at least you and the employer split Social Security and Medicare costs.
- Better bucket. Things become more favorable with this bucket, though you don’t sidestep the government’s clutches completely. The income sources in this bucket include rents, royalties, interest and short-term capital gains. Why do these income sources fare better than wages? For one thing, you don’t pay any Social Security or Medicare taxes on them. But you do pay ordinary income tax based on your tax bracket, which can be as much as 37% depending on how much taxable income you have.
- Infinity bucket. This is the bucket where you begin to put real distance between your money and the government’s eager grasp. The best source of income is real estate because, while there are property taxes, it’s possible you will never pay any tax to the IRS on your real estate no matter how high its value grows.
Stock dividends are another example of an income source that fits into the “infinity bucket” because they are taxed at the same rate as long-term capital gains rather than the ordinary income rate. The long-term capital gains tax is either 0%, 15% or 20% depending on what your tax bracket is. If you’re in the highest bracket, which is 37%, then the most you would pay on capital gains is 20%. Compare that to wages where you can pay as much as 37% and you also have to pay those other payroll deductions such as Social Security and Medicare. Add all those up and you can see that capital gains give you half the tax liability of wages and sometimes less than half.
So, how might this play out for you? Think about it this way: Let’s say you came into my office in search of financial advice and I asked whether you would rather have a 7% return on your investment or a 10% return. You likely wouldn’t hesitate to go for the 10% return.
But the correct answer to my question is “it depends.” If the 7% return is tax free, but the 10% return is subject to 37% federal income taxes, 2.9% Medicare and 13% state taxes, you would be better off with the 7% return. All too often, individuals fail to take the important step of calculating the after-tax return of their investments. Wealthy individuals understand how generating returns in the infinity bucket minimize taxes in the long run and are keen to invest in rental real estate, dividend stock, tax-free bonds and other tax advantaged investments.
If you aren’t wealthy today but hope to be wealthy someday, how can you edge your finances in the direction of the infinity bucket and that potential tax-free return on your investment? One of the most effective tools for locking in tax-free wealth is to use a tax-advantaged account such as a Roth IRA or a Roth 401(k). Unlike traditional IRAs and 401(k)s, the Roth versions grow tax free and you don’t pay any taxes when you begin withdrawing money in retirement. Within your Roth, you can invest in a multitude of things, such as stocks, bonds and exchange-traded funds, among other options.
Let’s say you set up a Roth IRA. Through that account, you could buy dividend-paying stocks such as Altria, 3M, Walmart or Walgreens. Because you invested in the stocks through your Roth you will avoid taxes completely on all your gains and all your dividends.
Of course, this Roth approach builds the most wealth when you are further away from retirement because you have many more years for that money to grow. If you are nearing retirement, or perhaps already there, focusing on the better and infinity buckets is still important, but you might do it through rental real estate or through the direct purchase of dividend-paying stocks. That gives you steady income but with a tax burden reduced from what you might otherwise have.
As the three buckets make evident, the IRS doesn’t view all income sources the same way – and since the IRS doesn’t, neither should you.
If you want the government to get a smaller cut of your money, then it’s critical to keep in mind the different ways sources of income are taxed – and to explore ways you can make sure more of your money comes from the better bucket and the infinity bucket.
About the author: Toby Mathis
Toby Mathis is the ForbesBooks author of Infinity Investing: How the Rich Get Richer And How You Can Do The Same. He also is a founding partner of Anderson Law Group and current manager of Anderson’s Las Vegas office. He has helped Anderson grow its practice from one of business and estate planning to a thriving tax practice and national registered agent service with more than 25,000 clients. In his work as an attorney, Mathis has focused exclusively on areas of small business, taxation, and trusts. Mathis has authored more than 100 articles on small business topics and has written several books on good business practices, including Tax-Wise Business Ownership and 12 Steps to Running a Successful Business.