Looking for tax strategies to owe less to the IRS this April? Or better yet, going after a larger refund? The tax laws are always changing, so it makes sense to maximize your return.
In the United States, we have a progressive tax system. Meaning, people who earn more should pay a higher tax rate than those who pay less. This approach is based on fairness and an “ability to pay”.
What is interesting, however, is that the American tax system is only progressive up to a point. It is progressive for lower and middle class Americans, but it is not for wealthy individuals.
For example, in 2015 the effective tax rate peaked at:
- 29.3% for taxpayers who earned $2-$5 million
- 28.8% for taxpayers who earned $5-$10 million
- 25.9% for taxpayers who earned $10 million or more
As you can see, at the highest income levels, people who earn more actually pay less in taxes. That’s a pretty sweet deal, right? This is because high earners in the US have more access to ways to shield their income to avoid paying taxes.
Playing the “Tax Game”
While it’s a complicated question—and there is, of course, much debate surrounding it—it is true that the richest members of our nation have a greater ability to control their tax bills.
The consequence of this is that the tax code unfairly burdens the middle-income tax bracket, where the tax system is progressive, with earners paying paying up to 37% in federal tax.
On the upside, wealthy Americans (making $2M, $5M, $10M or more per year) do contribute to our nation in the form of real estate development, business growth, job creation and charitable contributions. Meaning, there are contributions from these individuals outside of the tax system.
Unsurprisingly, nothing is entirely “good” or “bad” — rather, it is simply valuable to consider how to optimally apply the tax law to your individual situation.
Plus, the hard truth is that there is little utility in being angry about the way the tax code is being applied (at least until election day).
What is useful is to emulate the activities and tax strategies of the wealthy—albeit at a smaller scale.
Tax Strategies to Protect Your Money
Thankfully, you too can play the “tax game” by modeling the behaviors of the wealthy, in the ways that you can. Specifically there are three key tax strategies that you should adopt, immediately. These strategies are described in detail below.
1. Lower your taxable income that the IRS uses to calculate your taxes owed.
To apply the tax strategies of the wealthy, you’ll first want to take advantage of various savings accounts, along with credits and deductions that apply to you.
One of the reasons that I love real estate investing is that the IRS tax code is littered with deductions and credits related to this activity, from mortgage interest deductions, to depreciation deductions, 1031 exchanges, primary residence capital gains tax exclusions, and so much more.
While you may not love real estate as much as me, ask yourself, what parts of the tax code could apply to you? Might it be:
- Charitable Contributions
- Home Office Deductions
- Travel Deductions
- Work Related Education Expenses
- Mortgage Interest Deductions
- Student Loan Deductions
- Residential Energy Credits
- Health Savings Account Contributions
- Capital Gains Exclusions for Home Owners
- Or, something else?
2. Get your money invested so it that multiplies and is taxed at a lower rate.
Next, you need to get your money invested, because it will position you to have a greater percentage of your income come from capital gains (“passive income”), instead of earned (“active”) income.
This is one of the key tax strategies of the wealthy, because capital gains are taxed at favorable, long-term rates that top out at 20% for assets owned for one year or longer.
Specifically, capital gains tax rates are only 0%, 15% or 20% for assets held 12+ months. (For assets owned less than a year, capital gains get taxes the same as ordinary income, so from a tax perspective, it’s usually advantageous to hold assets for a year or more.)
Capital gains are defined as profits from the sale of a property or investment.
Examples of capital gains include dividend payments, stock profits, Bitcoin profits, real estate profits, profits from the sale of a business, etc.
Also, when you get your money invested, it will start compounding for you, multiplying every day and every year—without your involvement. Because you can keep working and your money will be working for you, this is how you stack income sources like the wealthy.
Best of all, you don’t have to do this at a large scale to start reaping the benefits.
For example, let’s say you earned $50K at your job this year. Next year, you again make $50K from your job, but also make $5K in passive income, for example, from the sale of a stock that increased in value. That’s a 10% improvement in your gross income and the extra $5K you made will most likely be taxed at a lower rate than your earned income if you owned it for 12+ months.
Pretty awesome, right?
Plus, compounding is one of the world’s greatest forces, often called the “8th Wonder of the World“. At a 10% rate of return, your money will double in value approximately every 7.2 years. That means it will quadruple (4X) in value in only 14-15 years. That’s incredible.
3. Continually learn about taxes.
Finally, wealthy people tend to give enormous attention to their tax strategies, learning about them, brainstorming with their peers, and hiring smart professionals to advise them.
Remember, tax law is always changing and it pays to understand how it affects your personal finances.
Best of all, you can do this too—for free.
Accounting firms have published thousands of articles on tax topics which you can read online. Or, you could schedule a free consultation with a tax professional to see if hiring them would save you money beyond the fees they’ll charge. There are also hundreds of YouTube videos about tax strategies.
I frequently remind people that if you were to learn about only one new tax deduction each year, the compounding effect of that action over 50 years would be profound.
To help people to best understand tax strategies, I liken it to playing a game of Monopoly. In both cases, you must follow the rules (in the case of taxes, it’s the law), but there are also clear strategies that you’ll want to learn and implement.
As Warren Buffet says, “Learn more to earn more.”
Tax Strategies for Life
In summary, the American tax system is progressive (increases with income) for lower and middle class Americans, but the wealthiest Americans tend to get proportionally greater tax relief.
Given this reality, what can you do to best position yourself within the existing framework? What can you learn from the wealthy and how can you model them on a smaller-scale?
Let me know your ideas in the comments below or feel free to ask questions.