In Part 1 of this post on avoiding income taxes, we covered the wild option of moving to a foreign country and working remotely. Now we are going to focus on a simpler method to eliminating taxes so you can retire earlier and wealthier. That involves getting most, if not all, of all your income from stocks.
Getting as much money as you can into stocks and then living off the proceeds
Ever heard someone complain about tax loopholes that the rich abuse to keep from paying high taxes? Hear the one about Warren Buffet having a lower tax rate than his secretary? Me too. Did you know they apply to everyone? I do. And now you do, too. See, the problem is that most of us normal folks have what is called "wage" income and that is always taxed. The more wages you earn, the more taxes you pay at a higher rate. Fun! But capital gains...those are taxed differently. And this is where being a low- or middle-income earner comes in handy. Read this carefully:
If your tax rate is in the 10% or 15% bracket...you pay NO INCOME TAX on long-term capital gains. NONE!!!!
So what we are going to try to do then, is do whatever we can to get us into those two bottom tax brackets. So if you are in your earning years, you are putting every single cent you're allowed to in tax-deferred accounts by following these steps:
- If your employer offers 401k (or similar) then you'll want to contribute up to the employer match then go to step 2. If your employer does not offer a match or you do not have a retirement plan at work, go to step 2.
- If you qualify to contribute to an individual IRA (not a Roth), contribute up to the maximum then go to step 3.
- If you have a 401k and have not maxed it out, contribute as much as you can until it is maxed and then go to step 4. If you do not have a 401k or it is matched, go to step 4.
- Contribute everything else you can to a regular, taxable investment account.
These are pretty simple steps. And I know some 401k plans are terrible, but if you are putting away 50% or more of your income as we suggest, then you won't be working there for long anyway and we have a plan on how to make all of that money tax-free as well. What we have done is we have reduced the amount of those nasty 'taxable' wages to as low as we can. Eventually you will stop working (hopefully sooner rather than later) and then ALL of your income will be investment income. So back to not paying taxes...
Once you have all of your income in investment accounts and have stopped earning wages, we can make the changes necessary to get our income tax liability down as low as we can. If you don't have millions upon millions in your nest egg, it's not that difficult. A lot of these numbers fluctuate because how much tax you owe is based on a lot of factors other than what you make (family size, standard or itemized deductions, miscellaneous tax credits, etc.) so I am just going to use the numbers that apply to our family and you will have to make your own adjustments. I am NOT including the Foreign Earned Income Exclusion in the scenario below since that is a special situation and we are assuming my wife is no longer working.
There are two adults and two kids. Being married filing jointly in 2016, right off the bat with standard deductions we pay no income taxes on the first $28,600 no matter where it comes from, wages or investments. Projecting for 2016 that we have the following investment income:
- $5,000 in ordinary dividends (taxed at ordinary tax rate)
- $15,000 in qualified dividends (0% tax in bottom two tax brackets; otherwise taxed higher)
- $17,500 in short-term capital gains (taxed at normal income bracket)
- $22,000 in long-term capital gains (0% tax in bottom two tax brackets; otherwise taxed higher)
Adding it all up...that's $59,500 in total income. Notice that we are normally taxed on our short-term capital gains and ordinary, non-qualified dividends income of $22,500. However, our standard deduction knocks clears those taxes off the board, so our effective tax rate on those is 0%. The qualified dividends and long-term capital gains are also not taxed because our "low income" has us in the 10% bracket. So we pay $0 in taxes. Yay!
But what if we want to make more than that and really live in style? That's ok. Even if we DOUBLE every single number in the above scenario, we still end up paying $0 in federal taxes. Go ahead and find an online tax calculator and put in the numbers (doubled, of course) and see for yourself. In fact, for our family in 2016 in this scenario I have already calculated that (depending on the type of investment income and tax rules) we could take in up to $118,000 of income and still owe zero dollars in income taxes.
So what is the takeaway from all this? You should be cramming as much money as you can into retirement and investment accounts while you are working for wages and do everything you can to reduce those wages. Then, once your investment income is greater than or equal to your earned wage income, you live off of that investment money and put 100% of your paychecks into retirement accounts in order to keep the tax man at bay. That way you can still keep working, have the same income you did before, but additionally receive preferential tax treatments as well. Congratulations...consider yourself part of the 1%. You're welcome!
How close are you to being able to invest 100% of your paycheck? Have you found a way to reduce your taxes legally so more money goes into your pocket? Let us know in the comments below!