Uncle Sam wants his cut. Part of being a functioning member of society is paying our tax bills. Taxes are very important to the operation of a successful nation. That being said, we still want to ensure we legally pay the least amount of taxes that are required.
Lowering our tax bills will require financial education. We are starting the Taxes 101 Series with the intent of providing the truth of taxes in America. This is not an in-depth analysis because taxes are always a moving target. Instead, this is meant to change your mindset towards taxes. In order to take action, you will need to seek a tax consultant.
For Taxes 101, we are going to look from the broadest view that we can. From a bird’s eye view, if you will. We need to first understand income. Knowing the three different types of income will help us make future decisions on our investments. Robert Kiyosaki, the author of “Rich Dad, Poor Dad”, says that the three types of income are ordinary (we prefer saying “earned”) income, portfolio income, and passive income.
How the Rich Buy Their Bling
Knowing these types are income should change your life. Understanding these types of income will explain why the rich get richer and the poor get poorer, and also why the middle class is becoming poorer as well. Let’s discuss the three types of income.
Earned Income (22-50%). This is the worst type of income, by far. Workers pay the highest taxes. On top of paying income tax, we will have to pay the Federal Income Contribution Tax (FICA) Tax. This is for Social Security and Medicare.
In 1935, the federal government created the FICA Tax Act. At that moment, we paid the government before we paid ourselves. The FICA tax, sometimes called the payroll tax, is 12.4%. Our employer pays 6.2% and we pay the other 6.2%. If we are self-employed, we will pay the full 12.4%. We will have a complete article on the disadvantages of being self-employed.
Next, on top of that, we have to pay income tax. Based on the current income brackets, most of us will fall into the 24-37% range. Finally, we may have to pay state tax and municipal tax, if applicable.
All said and done, we could be paying 30-50% of our earned income in taxes. We would then try to live our life with the remaining money. Most of us will start with earned income, but we will need to convert this earned income into the other two types of income. Owning a business will give us great leverage over our taxable income, but I will have a separate article on this.
Portfolio Income (15-20%). This is income from capital gains. Capital gains are when we sell something for more than what we paid for it. This can apply to stocks, bonds, real estate, artwork, gold, precious metals, boats, cars, etc…
There are two categories of capital gains, short-term capital gains, and long-term capital gains. Short-term capital gains are anything held for less than a year. And long-term capital gains are for anything held for over a year.
Living a Middle-Class Life is Stressful
The tax rate for short-term capital gains will match our income tax rate. However, keep in mind, we will not be paying the FICA tax on top of short-term capital gains taxes.
The long-term capital gains rate is either 0%, 15%, and 20% based on our income. Currently, the cutoff amount between 15% and 20% is $441,450. So most of us will fall into the 15% tax rate.
So now, let’s start putting this into practice. Let’s say that we quit our job on January 1st of a year. We did not have an earned income job. We sell our house for a $400,000 capital gain. Since we lived in the house for the last two years, we did not pay taxes on the first $250,000. More on this in my real estate article.
This leaves $150,000 to be taxed at 15%. After taxes, we will have $127,500. We would have a total of $377,500 after our sale. That is amazing. If we could live off $50,000 a year, that is 7 years we could live before we needed to sell something else.
The best part of portfolio income is that we can control the amount of income that we make. We control when to sell. We should also know precisely how much in taxes we will pay. Think about how much you would owe on an earned income of $400,000 a year. Are we starting to see why income types are so important?
Passive Income (0-20%). We want to convert our earned income into passive income. Passive income is interest from bonds, dividends from stocks, rental income from real estate, royalties from media, and royalties from intellectual property. Passive income is also called CASH FLOW.
Interest and royalties are taxed at the earned income rate, but without the FICA. Interest is taxed this high because the government knows that most people want to leave their money in a savings account. So not only is your savings account fighting inflation, but Uncle Sam is taking his cut as well.
Dividends are taxed at the same short-term and long-term rates as capital gains. We should buy and hold our dividend-paying stocks to pay the lowest taxes on our dividend income.
The granddaddy of all passive income is rental income. That is because real estate has enough tax advantages that, with the right financial education, we could pay 0% on your rental income. Using terms such as depreciation and interest deduction, we can work our rental income down to 0%. Please seek the advice of a tax consultant before going to buy a huge home.
Now that we know the three types of income, can we see why those who focus on portfolio and passive income will have a lower tax bill? Let’s take a step back and truly evaluate why the rich are getting richer. Also, keep in mind that the rich are also leveraging even more tax advantages such as businesses to create even more wealth.
Stock Market Investing 101
In the example before, our family sold a house and walked away with $350,000+ after taxes. They can live off $50,00 a year, so they are good on money for 5-7 years. What do you think they are doing for those 5-7 years? I tell you what they are not doing, WORKING.
No, they are looking for more deals and investments. They are creating royalties from books, blogs, and videos. They are creating real estate notes. They are finding ways to finance investment deals with OPM (other people’s money).
We can put it all together to get the full view. They used their tax education to take $350,000+ from an investment. They are simple enough to live on this for over 5 years. In the meantime, they are building other sources of income, without using their nest egg. By the time their 5 years come up, they will have over $1 million because they are working smarter not harder.
During the same 5-7 years, the workers (earned income) are still, working. There is a chance we are out of debt, maybe. We might be lucky to have $25,000 in the bank. It will be in a savings account, of course. We will buy a nice car with a loan. If we get lucky, we can buy another liability, a boat. Now, that’s life. We have no idea of portfolio and passive income and are not trying to obtain assets that will produce those types of income. We will blame the president, the government, and the “system.”
This is just the start of our tax series. Please reflect on the three types of income. Outside of taking care of our families, our main role in life is to convert earned income into a portfolio and passive income. If we buy a house at age 30, there is a chance that in 30 years we can gift it to our children. They can be the family in the earlier scenario, living off of $350,000. Even if we are buying $100/month of dividend-paying stocks, it is a start in the right direction. It also shows that we understand the principles of the 3 types of income.
The next few articles in the Tax 101 series will include more on the tax benefits of real estate and owning a business. Also, we will focus on the disadvantages of being self-employed and how to best employ your 401K and Roth IRA for our future retirement lives. We highly recommend reading “Unfair Advantage” by Robert Kiyosaki for a complete mindset overhaul. This is life-changing education.
Get Your Free eBook:
Follow us on our Facebook Page:
https://www.facebook.com/kingmarine1775
Join our Facebook group at:
https://www.facebook.com/groups/231490384820780
Follow us on Pinterest at:
Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Leave a Reply