Do you know the fastest way to build your wealth is not by controlling your expenses or investing more but by reducing your taxes? That’s the real gateway to Tax-Free Wealth. Especially if you are living in the United States, you might be paying anywhere between 30-40% taxes just on your income. If you account for taxes paid on all other purchases you make throughout the year, the actual taxes may even be higher.
In other words, we are working the first 6-7 months of a year just to pay taxes to the government.
First time I had heard this a couple of years ago and at that time this thought had turned my head 360 degrees. Not physically though, I am not an owl.
So, I set myself up for the challenge to explore more about how to reduce taxes over last few years. Recently I came across a must read book called Tax-Free Wealth by Tom Wheelwright. Why I think it’s a must read will be obvious by the end of this post, so keep reading.
Tom did a great job of simplifying the tax code for novice and loaded a book with lots of tax-saving tips.
I started reading it 2 days ago and couldn’t put it down. Actually I did put it down after I passed out at 2 a.m last night and once after getting threats from my wife – “honey, dinner is getting cold, are you joining us or should I feed it to dogs?” Jokes apart. She asked me politely and there was no mention of dogs. 🙂
Getting back to the subject.
What the heck is Tax-Free Wealth?
Well, it’s here. Tax-Free Wealth.
By reducing our taxes we have great potential to boost our wealth-building machine. Think about it, what is the biggest fixed cost to your earnings?
No, it’s not your lifestyle.
It’s neither your house nor your car.
Did I hear someone whispering in my ears? – ‘my wife’. No, not even her.
It’s your taxes.
Your taxes are the biggest fixed cost to our earnings. And if you are an employee or self-employed specialist like a Doctor, Lawyer, etc, then you are the worst-hit – says Robert T. Kiyosaki in his book – Why The Rich Are Getting Richer?
As I have an analytical mind and love to bring my spreadsheet, let us see if he is true?
Do we really pay over 50% in taxes?
Below are tax brackets and rates for 2020 in the USA. These are federal tax rates that everyone has to pay.
Let us keep it simple and take a case of Mr. Joe who is earning $125,000 a year fully ignorant of any potential tax savings he can do using tax-free techniques.
Since Mr. Joe is living in Massachusetts state which penalize it’s residents with a state tax of 5.05%. So, he will end up paying additional taxes on his income. Here’s a simple tax estimator for 2019-2020 filings.
As you see I am intentionally keeping this guy on the worst side of income tax. He could reduce his taxes by doing retirement contribution in 401k but I am assuming his employer doesn’t offer 401k plans. Bad luck for this guy.
As you notice, he will end up paying over 29% of his earnings into taxes to Uncle Sam.
So, is he in good situation as he is paying taxes below 50% we thought we all pay?
No, we didn’t account for all other expenses which we will do out of his take home $88,101.
He will rent an apartment and will be forced to buy rental insurance? Which will include some sales or service taxes. Usually between 7-9%.
Then he will buy a car or lease it. In both situations, we will pay the excise tax and sales tax which is again around 7-9% depending upon which state you bought or leased the vehicle.
The next item is the groceries. Yes, you will pay taxes on groceries too except some essentials which are subsidized by the government like salt, milk (in some states), etc. This tax is around 2-7% depending upon which state you are in.
What about utilities? Yes, you pay taxes on electricity, internet, phone, gas, water bills. Sometimes these taxes are not shown explicitly on the bills but included in the cost itself. This is just to make you feel good about the bill and hide the ludicrous amount you pay in taxes with after-tax money.
Here’s an example of such an offer.
If you don’t see taxes mentioned in your bill, assume they are included in the price you are paying.
Now assuming that Mr. Joe’s yearly expenses are about $60,000 which includes an average tax of 6.5%, or $3,900 paid in taxes with take-home earnings.
If we add this to our calculations, it turns out to be an additional 3.12%. So the next taxes paid by Mr. Joe ( our worst saver ) is about 33% of his earnings.
I might have missed some other expenses or taxes but you got the idea. The overall taxes paid are around 33-35% for someone earning $125,000 a year.
Having said that, I still think the taxes will shoot up even higher as your earnings and expenses increase. Look at the highest tax bracket for tax rates for different earnings ranges. The highest is about 37% federal. This alone will add 15% to Mr. Joe’s 33% calculated above. So, 50% of earnings spent on taxes is really possible in the US.
Great Ideas in Tax-Free Wealth Book
Here are a few ideas I liked as a small business owner in the book: Tax-Free Wealth. I didn’t know them before and certainly, my accountant didn’t do a great job in guiding me on how to save tax on business income.
I am sure the same problem is being faced by many small business owners that their accountants aren’t fully committed to finding ways to save tax.
This is a wake-up call for me to change him and find someone more committed.
Tom in his book discussed following interesting ideas towards tax-free wealth building which are applicable for business and active investors:
- Depreciation – If you own rental properties or machinery, computers and other equipments for your business, you might be able to claim a percentage of your cost as a depreciation deduction. Suppose you bought a residential property for $1,000,000. As per tax law, you are eligible to claim a deduction of 3.6% of property cost every year in your tax returns. For commercial properties, you get a 2.5% percentage deduction. For business equipments or software; you can claim up to 20% of the cost every year for the next 5 years in your tax returns. This means you get your money back in installments as tax deductions.
- Travel Expenses – Tax laws allow you to claim travel expenses as long as you traveled for the business. It could be a meeting or visiting a client, or manufacturing plant, etc. You can claim those expenses as business expenses.
- Meals – You can claim business lunch with clients or teams. As per Tom, you can even claim a lunch with your wife if the meeting was for discussing business and she is part of the company. A word of caution from Tom is that don’t overdo it or buy expensive lunches or dinner. Keep it under sensible limits to not flag any red flags.
- Property Taxes – Your business paying property taxes for office space or rental properties if you are in real estate business, then you can add those taxes as expenses in your business income.
- Charitable Donations – Businesses donating for charitable causes can claim deductions in their tax returns for up to 100% of the amount donated. I suggest you consult your accountant before making any donations though just to be sure if specific organization is covered under approved charities.
- Choosing the right LLC type – It’s important to start with the right type of LLC. Per Tom, it’s always better to start with single-member LLC or a sole proprietorship as it demands less paperwork and overhead. When your business is earning high revenues then switch to S-Corporations. It will demand more work for you but the tax savings are way better in S-Corps than single-member LLC.
- Mindful Business Expenses – Tom in his book – Tax-Free Wealth made a good point which we all ignore after a while. Everything you do in business will either reduce or increase your taxes. Be mindful of your everyday business decisions and think about tax impacts too.
- Put Kids to Work – You can hire your kids to help with the business and pay them in return. Anything paid to your kids will be marked as an expense to your business. If your kids are making less than allowed exemptions a year ($6,500), they won’t have to pay any taxes. As a business owner, you should ensure they are reasonably paid and certainly not more than an expert or an experienced person for the same job. Here’s what I would love; pay kids $3000-4000 a year based on how much work they did and then direct that money to their Roth IRA account. This way you will build retirement wealth for your kids tax-free.
- Leverage Debt Intelligently – This is an idea I got while reading this book. As a business or investor, I can buy a rental property (preferably residential since it offers higher depreciation 3.6% vs 2.5% for commercial properties in the US) using low-interest debt. I think the overall cost to property will be zero to me if I add property depreciation + mortgage interest deduction + rental income. Moreover, the property value appreciation over the years will provide additional profit. I still need to work out the math but at the surface seems a profitable deal.
- Real Estate Rollover – According to Tax-Free Wealth book, the author suggests that you can buy and sell real estate properties without paying any taxes on the appreciation. The way it works is as follows. Say you bought $100,000 property. After 5 years it’s worth $200,000. Now if you sell it and put the profits into your pocket, you will end up paying 30% + tax on the profit of $100,000. That’s $30,000 in tax. But if you buy another property worth $200,000 with this same money, then you won’t owe any tax to the government. What you get out of it? You get to raise your purchase point which will save you taxes should you decide to sell this second property in the future. This way you can keep raising your real estate portfolio tax-free.
- Inheritance Tax – Suppose you have $1,000,000 worth of real estate properties built on an initial $250,000 investment. If you pass those to your children after you die, they won’t be taxed on $750,000 of profit. In fact, for them, the property value will start from $1,000,000. So, the next day if your children sell that property for $1,000,000 there won’t be any taxes. This sounds an amazing way to build wealth for future generations. Of course, they can do real estate rollovers as mentioned above to grow the wealth even further after you are gone. That’s how rich get richer one generation over others. I suggest consulting with your tax advisor to put this into place rather than doing it on your own as it’s a bit complex than I can cover here.
- Know your Tax Base – Author Tom talked about a strategy to reduce tax for self-employed and business owners using reducing the tax base. According to this, you should explore the possibility of turning yourself as an employee to your own business and get a reasonable salary for the work you do. You can also get a dividend payout from your company as you are the owner. The dividend is taxed at a lower percentage than income tax. This strategy will reduce taxes for high income generating self-employed workers.
- Financial Freedom and how to get it fast
- How to get rich doing nothing, that right
- How I made $3479 in an hour
- The most powerful tax saving trick using by super wealthy families
Tax Saving Tips for Employees & Self Employed
Tom in his book – Tax-Free Wealth didn’t cover tax-saving ideas for employees or self-employed specialists, but here are few deductions and credits which any employee or self-employed specialist can claim in their tax returns:
- Max Up Retirement Contribution Limits – This is no brainer. If your employer offers a retirement plans such as 401k, then contribute to it as much as you can. The best is to meet a $19,500 limit (as of 2020).
- Don’t leave money on the table – If your employer offers retirement plans such as 401k, then they might also be offering match up to a certain percentage of your contribution. Make sure you contribute enough to take all the money that the employer offers.
- Invest in Traditional IRA – It works similar to 401k retirement plan. Based on your income level, you will be able to invest up to $6000 in pre-tax money. The earnings or withdrawals from IRA will be taxable in the future though but it’s still a good choice to make. You can also transfer funds from IRA to Roth IRA to benefit from tax-free withdrawals later.
- Saver’s Credit – Anyone with income less than $32,000 (single) or $64,000 (married filing jointly) can claim a credit of up to $1000 (single) or $2,000 (married filing jointly) if they have saved money for retirement through 401k, 403 or IRA.
- Opt for Standard Deductions – Unless you can itemize your deduction and claim more than $12,200 for single and $24,400 for a married couple filing jointly, go for the standard deduction. It’s easy and offers maximum standard deduction without hassle.
- Flexible Savings Account – Commonly known as FSA. There are 2 types; FSA for Health and FSA for dependent care. These accounts allow you to keep a certain amount of pre-tax money aside and use it only for expenses related to health and medical care or dependent care such as pre-school or daycare for kids. If you a kid who goes to preschool or daycare since you and your partner both work, you can pay for those expenses tax-free using FSA for dependent care. It allows you to save a couple of $100 in taxes.
- Health Savings Account (HSA) – It is similar to FSA health care but it’s only eligible for those who have high deductible health coverage. The contribution and withdrawal from this account are tax-free as long as it’s related to medical expenses. You can contribute up to $3500 (single filer) or $6,900 (for a family) in a year. This savings in this account can further be invested like IRA accounts. It works as a tax-free medical expense account.
- Claim mortgage interest in tax – Although I don’t think we should buy a home to save taxes and I have written about it why in my post. But if you have a home or plan to buy it, then you can claim part of your interest payments in tax credits.
- Claim Child Care Tax Credit – For your children under 17 years, you get a child care tax credit of $2,000 per child. This is great because it’s a credit on the tax you owe and not on your earnings which means more money for tax-free wealth building.
- Pass-through deductions – This is for self-employed specialists such as doctors, lawyers, accountants, etc who earn their earnings through a pass-through entity such as LLC, sole proprietorship, partnership or S-corporation. It’s limited to certain occupations and only high-income taxpayers. So, check this out if it is valid in your case. If it is, then you can get an additional 20% deduction on your earnings. For example, if your LLC made $110,000 this year, after 20% deduction, you will only be liable for tax on $88,000 minus any expenses and other credits.
- American Opportunity Credit – If you or your children are studying an undergraduate program, you can get a credit of up to $2500 a year. This credit is only available for students and their parents who paid for the tuition and books. It doesn’t include living or transportation expenses. Tip: You can learn for free. Find an online course or courses which doesn’t cost you more than $2000 a year. Then claim your tuition and cost of books in tax credits which you also improved your resume or skills. Check with your CPA if a particular undergraduate program fits this credit.
- Lifetime Learning Credit – This tax credit allows you to claim up to 20% of the first $10,000 spent in tuition or books. It’s similar to American opportunity credit mentioned above but it’s not limited to undergrad students or parents. The credit applies to undergraduate, graduate and non-degree or vocational students, and there’s no limit on the number of years you can claim it, unlike American opportunity credit which is limited to 4 years. Just keep a note that you can’t claim both the American opportunity credit and the lifetime learning credit in the same year.
- Earned Income Tax Credit – The Earned Income Tax Credit is a refundable tax credit for low- and moderate-income workers. The amount depends on the income and number of children. People without kids can qualify. For the 2019 tax year, the earned income credit ranges from $529 to $6,557. For 2020, it’s $538 to $6,660 if your adjusted gross income (AGI) is less than $57,000.
- Property Taxes Deduction – You can claim up to $5000 (filing single) or $10,000 against the property taxes you paid on your home, land, vacation home, property outside the USA or even on boat, RV and car.
- Home Office Rental Deduction – This is for self-employed or people using their home as an office for business. You can claim the part of your rent as office expenses and bring your tax bill down by 10-20%.
- Tax Deduction for Teachers – If you are a teacher, you can get a $250 deduction against school supplies.
- Green Energy Credits – If you installed solar panels in your home, you can get up to 30% of installation cost in credits.
- Trading in Roth IRA – As covered in my previous post, Roth IRA offers tax free withdrawals. So, if you buy and sell stocks, earn dividends which are reinvested in stocks and earned you more gains, will all be tax free. Since IRAs are meant for your retirement, I will recommend paying caution when using this account for trading stocks or any other risky assets.
I am sure you didn’t know about most of the above tax credits and deductions which you can claim as an employee or self-employed specialist.
You should check your last year’s return and ensure that your tax advisor or accountant claimed all the eligible tax deductions and credits for you. If not, call him/her now to understand why.
As you Tom has done a great job in providing lots of tax saving tips which are often missed by our tax preparers. In the book he has also explained how to select a good tax preparer who wants to maximize your tax savings.
In the end, I found this book quiet interesting to read and I learned a lot from this one. It will surely be on my self for many years to come.
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