Secrets of the Rich
In the past two editions, we have covered the Seven Proven Steps that the rich use to make and grow their money. In the first edition, we covered the overview of the system and debuted the seven steps:
- Create a Business.
- Discover Your Hidden Business Deductions.
- Pay Your Taxes.
- What's Left Goes Into Real Estate.
- Real Estate Income Comes Out Tax-Free.
- Buy a House the Right Way.
- Make Your House Give You Money.
Last month we discussed how to discover your hidden business deductions. It's tempting to just stop at that step in the creation of your tax plan. In fact, mainstream tax planning emphasizes only write-offs. A good tax strategy should include three main parts:
- Reduce taxable income (or change the character of the income)
- Increase the amount of deductions (Step Two)
- Decrease the tax rate applied to the taxable income
Reduce Taxable Income
Taxable income (the type you report on your tax return) is comprised of three different types of income:
- Earned income – you work for your money
- Portfolio income – your money works for you
- Passive income – your investments work for you (primarily real estate)
Most of us were taught if we wanted something, we needed to work for it. If we wanted more money, we were taught to work harder. That's earned income. And, it's the highest taxed income there is – the federal rate (including payroll taxes) generally tops out at about 45%.
Portfolio income doesn't require your hard work. Your money works instead of you. Portfolio income includes interest, dividends and capital gains. (Capital gains occur when you hold an asset for over one year and then sell the property at a profit.) The majority of portfolio income comes from dividends and capital gains. And, those types of income have a maximum tax of 15%. I find it amazing that the thing we were taught to do – work hard – will cost us three times as much tax!
Passive income is primarily income that comes from real estate. When you set real estate up correctly, you'll be able to pay only 0% in taxes.
Other Types of Income
Besides taxable income, there are two other types of income that don't make it onto your tax return. These are:
- Tax Deferred
- Tax Free
Tax deferred is taxed later, whereas tax free is "taxed never." Examples of tax deferred income includes a Section 1031 like-kind exchange (covered in more detail in Step 5) and a 401(k) plan or, for that matter, any other type of traditional pension plan.
Examples of "tax free" income are the tax free gain from the sale of the principal residence (Step 7) or the tax free growth that you can get in a ROTH pension plan.
One part of a good tax strategy is to move income from the higher earned income into portfolio, passive, tax deferred or tax free income. That's what you'll see in the rest of the steps!
Our tax system is a graduated tax system. That means there are different layers of tax on the income we make. The first income we earn is subject to a 0% tax rate, it then moves into a 10%, 15% and on to 35% tax rate. It's easiest to think of the tax rates as layers. As you make more money, you will still pay tax at a 10% rate on the first level and so forth. The term "marginal tax rate" refers to the tax rate you'll pay for another dollar earned. If you're at the highest tax bracket, that means you will pay 35 cents in federal tax for the next dollar that you earn.
Income Splitting Tax Strategies
One part of a tax strategy that addresses the graduated tax rate is to use "income splitting." This means that we move the top layer of tax rate into another person or entity's lower tax rate. So, if an individual was paying at 35% at his top rate he might pay his child for work legitimately done in his business and thus reduce the 35% taxed income (his level) and move it to his child's 0% rate.
This can also be accomplished by having certain types of businesses held within a C Corporation. A C Corporation is the only entity that pays tax at its own rate. In other words, the other types of business structures (partnership or S Corporation) flow through to the individual owner and are then taxable at a personal rate. The C Corporation has its own graduated tax rates. For example, the first $50,000 of C Corporation earnings are taxed at 15%. So, one strategy is to move some of the higher taxed income (35%) to a C Corporation (15%). Of course, this type of strategy must be customized for your own particular circumstances.
When Should You Pay Your Taxes?
Delay paying your taxes just to the point where a penalty would be assessed. Don't pay anymore than you are liable for when you calculate your withholding and estimated tax payments. A tax refund is not a present – it's payoff from an interest free loan that you just made to the government! And, they didn't even say "thank you!"
Make sure you (or your advisor) calculate estimated tax due prior to year-end. If you need to have more tax paid in, pay it as late as possible in the year and through your withholding (not estimated tax payments). By paying through payroll withholding, you will not be subject to estimated tax penalties for late payments. And by paying as late as possible in the year, you have had the best use of the money for your other investments.
In the next issue, we'll discuss how to invest the money from your business into real estate to convert the earned income into passive income.
Diane Kennedy is a CPA/Tax Strategist and the author of the best-selling book Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax and co-author of the best-selling book
Real Estate Loopholes: Secrets of Successful Real Estate Investing. For more information on how to legally use the tax loopholes and make the IRS your partner, contact Diane's CPA firm, DKA, at 888-592-4769 or www.dkacpa.com. Tax law is constantly changing! Keep up to date for free by signing up for a free e-newsletter at www.taxloopholes.com