So many of my affluent friends who are high earners are worried about the coming tax increases under President Obama. Many of us are already paying over 50% of our income in taxes when you add up our Federal Income Taxes, State Income Taxes, Property Taxes, Sales Taxes, Self-Employment Taxes, and the list goes on. Now the government wants us to pay even more. How can we lower our effective tax rates, you might be asking?
Well I’m not a tax professional, so I can dispense professional advice, but I can tell you what many of my friends are doing to lower their effective tax rates. If you are open to relocation, first check out my previous blog “Top 10 Island Tax Havens You Can Retire or Relocate To” . While relocation is not an option for many of us, because we have kids in school, family, or other responsibilities — I’ll give some details on how to lower your tax burden below without relocating.
The first thing you need to understand is that W-2 earned income is some of the highest taxed money you will make in your life. Part of your tax strategy should be to either lower your W-2 earned income, or find a way to make money elsewhere in less taxed investment vehicles. If your income is $250,000 per year, and let’s say President Obama sets your federal tax rate at 39%, that is a tough pill to swallow, right? But if you are able to make $100,000 a year, and take $150,000 of income in another vehicle that is taxed via long term capital gains tax, or dividend tax — Maybe your tax rate on that income drops to 15%? This is important to understand if you want to learn how to best structure your finances for a lower tax burden.
1). START A BUSINESS
Starting a business can give you a boat load of tax incentives and breaks that can lower your income tax. One of my favorite authors, Tim Ferris talks a lot of about this in his now famous book “The 4 Hour Workweek”. He uses the example of starting an online web store, or some sort of online business. Maybe you start it up part-time while you work your other job, and just build it at your own pace. If you incorporate into an S-Corporation, you can write off any losses you incur while getting started. These could be meals, computer equipment, business travel, or things of that nature. If your business is only a little profitable, maybe you maintain more losses than you do profits each year, and those losses can flow into your personally income tax return lowering your overall taxable income. Once you do get the business on its feet, the income will be taxed at a lower rate than your earned W-2 income, because you’ll be paying yourself a reasonable salary and taking the rest of the income as “dividends”.
2). OWN REAL ESTATE
By owning Real Estate, you can take advantage of such great tax shelters as depreciation on rental property, as well as lower tax rates for passive income. By earning passive income on rental property, for example, you can take the income and subtract business expenses like overhead, meals, travel, miles, etc first. Then you can take depreciation on your rental properties each year, and write off the interest you are paying on the mortgages of said properties. What’s left over can be paid to yourself via dividends mostly, and taxed at a very low interest rate — Unless maybe you rack up enough losses to balance out any profit you had, in which case the loss can pass through to your personal income tax return and lower your taxable base. Real Estate is a great long term investment vehicle no matter what, because it pays itself off over time and you can either keep it as a great cash flow vehicle, or you can sell it to access large sums of capital when you need to retire.
3). MAX OUT YOUR 401k at WORK!
If you depend mainly on a W-2 job for most of your income, it’s a definite no brainer that you need to max out your 401k deductions annually to reduce your taxable income. In 2013 the maximum 401k deduction is set to move to $17,500, so that means if you make $100k, you can deduct the max and reduce your taxable income to $82.5k, which is a nice tax savings for you. Upper income earners benefit disproportionally, since we make more and pay more taxes — So it is important to take advantage of this great tax benefit that really is built into the tax code for people like us. Obama and his cronies have already talked about trying to take it away or restrict it so that it does not work as a “loophole for the rich”, but thankfully he hasn’t gone down that road yet. See my other blog “Will Government Raid 401k plans Next?” for more info on that.
4). TAKE INCOME AS 1099 and NOT W-2 if POSSIBLE!
Maybe your company gives you the option of being a W-2 employee, or a 1099 contractor. If that is the case, it is almost always going to benefit you to be a 1099 contractor, because you’ll be able to incorporate yourself, buy your own health insurance benefits, and handle your own payroll through a payroll service provider like Paychex (Outsource your payroll needs. Learn more about options at Paychex.). The result will be that you can deduct all of your business expenses before passing yourself what the IRS calls a “reasonable salary”, which you’ll pay taxes on as earned income. The rest you can possibly direct to yourself as dividends from your corporation, and be taxed at a much lower rate.
5). PREPARE A TAX TEAM!
In order to guide you through a lot of the available tax shelters and steps you can take, it will be important to assemble a great tax team that you can count on, or if you are tax-savvy —
invest in some quality income tax software for doing your taxes at home. Either way, it’s important to stay on top of current tax laws, and make sure that you run tax strategy by a professional before putting yourself at risk. US Tax law is now more complex than ever before, spanning thousands of pages of text — and if you step on a landmine, the IRS will be there quickly to take you down to China Town.