Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part I. The Foundation
Chapter 3. Income
Not All Income Is Created Equal
It seems like politicians never tire of discussing whether the rich pay their fair share of taxes. In the 2012 election, there was much discussion in the political arena about the fact that Warren Buffett (one of the wealthiest people in the world) pays taxes at a lower marginal rate than his secretary. “How can a man who is worth billions and earns millions every year have a lower tax rate than his middle-class secretary?” they would say. “What tricks do his accountants and attorneys use to get his taxes so low? What secrets do they know?”
In reality, there is no secret involved in how he reduced his tax rates. The key to his tax prowess lay in the very open and obvious parts of the tax code that are related to income. Warren Buffett does not have lower tax rates because of complex schemes involving hidden deductions, credits, and offshore accounts. He has reduced his tax rate by shifting his sources of income to those given preferential treatment in the tax code.
The great news is that his “secrets” to lower tax rates are available to everyone. Even better, through conscious effort you too can shift your income to these preferred sources—lowering your overall tax rate every step of the way. To do so, you must first gain an understanding of each type of income and how each is taxed. Then you will be ready to carefully plan a way to get your effective tax rate as low as possible.
Here again is the list of the categories of income sources (from Chapter 2), each of which has a unique method of taxation:
· Ordinary income
· Tax-exempt income (no tax)
· Preferred income (lower than normal tax rates)
· Deferred income (eventually taxed, but not currently)
· Potentially or partially taxed income (including Social Security)
· Penalized income (higher than normal tax rates)
· Earned and unearned income
· Passive income
The remainder of this chapter is dedicated to a close-up look at each income source.
Ordinary income is the catch-all term for any income source that does not have special tax rates or tax treatments. Most income falls into this category and is taxed at “ordinary” income tax rates—those rates found in the income tax tables (the tax brackets that you are familiar with). The most common sources of ordinary income are:
· Salaries, wages, and tips
· Interest (not from state or municipal bonds)
· Dividends (non-qualified)
· State tax refunds
· Business income
· Capital gains (short-term)
· IRA distributions, pensions, and annuities
· Rental income
· S-corporation and partnership income
· Unemployment benefits
The highest tax rates that you pay will be on income that comes from these sources (other than those income sources that are penalized). In fact, some of these ordinary income sources fall into a special category known as “earned” income (explained in detail at the end of this chapter), which have employment taxes placed on them in addition to ordinary income taxes. It probably goes without saying that as you reduce the percentage of your income that is derived from these “ordinary” sources, the better your financial picture will be.
Tax-Exempt Income (No Tax)
As you might guess, the list of income sources that the government does not tax is very short. However, a few types of income do escape the levy of Uncle Sam. Usually these tax-exempt income sources are the best types of income to have when it comes to minimizing your tax bill. Not only are these types of income tax-free, but they also have no direct effect on your AGI (which means that they don’t have an effect on most of your deductions, your credits, or your marginal tax rates). The most common sources of tax-exempt income are:
· Tax-exempt interest (state and municipal bonds)
· Roth IRA distributions (within certain guidelines)
· Employing your own children (within limits)
· Workers’ compensation
· Certain insurance proceeds
· Some lawsuit proceeds
It is not in the government’s best interest to allow any type of income to be tax-free. So, of course, there are exceptions in the law wherein each of these income sources can be taxed. For example, portions of your tax-exempt interest can be pulled into the Alternative Minimum Tax calculation. Insurance proceeds can be taxed at times. Workers’ compensation payments that reduce your Social Security benefit are considered Social Security income for tax purposes and can thus be taxed indirectly. If you withdraw money from your Roth IRA at the wrong time, you are hit with a penalty tax, and so on. You really have to hand it to lawmakers—they will get you any way they can, even finding ways to tax your tax-free income.
Preferred Income (Lower Than Normal Tax Rates)
Those who write the tax laws often use the code as an opportunity to encourage (by taxing less) or discourage (by taxing more) certain behaviors. It is the preferred way to motivate the populace to do (or not do) certain things without blatantly taking away our freedom to choose. Examples of this would be the punitive taxes that are placed on tobacco products (discouraging behavior) or the deductions that come from saving for retirement (encouraging behavior).
One behavior that is encouraged and rewarded by the tax code is investing in business. If you are willing to put money at risk in order to start a business (or invest in an existing one) you are rewarded by the tax laws for doing so. The reward comes in the form of significantly lower taxes on income derived from such an investment. In this way the lawmakers encourage people to put their money at risk in order to grow the economy and bring innovation. As an aside, it is these sources of income (business investments) that are the “secrets” behind Warren Buffett’s lower tax rates.
In Chapter 2, I wrote about a client who told me that he would be earning $200,000 more income in the current year than in previous years. He wanted to know how much money he should set aside for the taxes on that income and I told him it would be somewhere between 0 and 50%, depending on the source of the income. I was relieved for him when I found out that the extra $200,000 was from the sale of a business that he had owned for many years. Selling a business is a great source of income from a tax perspective, because the bulk of such income is taxed at special rates—rates that are less than half of the rate that he would have been taxed if the income had simply come from the profits of operating that same business. This special type of income is called “capital gains” income.
Capital gains occur when you sell something for a greater price than you paid for it. The most common source of capital gains income is from investments. Capital gains income has its own special set of tax rates that apply if you have owned the asset for more than one year (known aslong-term gains). Short-term gains (when you owned the item one year or less) are taxed at ordinary income rates. Long-term capital gains income is taxed at a significantly lower rate than ordinary income. Lawmakers talk a lot about increasing these rates as a way to increase tax revenue, but at least for now long-term capital gains remain a great source of low-tax income. Some common sources of long-term capital gains are:
· Stock or bond sales
· Mutual fund ownership
· Sale of a business
· Sale of a home (sometimes)
Another type of income that is given preferential treatment is “qualified dividends.” Generally, dividends are taxed at ordinary income tax rates. However, if you receive dividends from preferred companies and hold the stock for a specified time period, you can then receive a preferred tax rate on that income. This special tax treatment for qualified dividends is to encourage long-term investments in domestic companies. The tax rate on qualified dividends is equal to the long-term capital gains rate. Long-term Capital Gains taxation is discussed in greater depth inChapter 11.
Deferred Income (Eventually Taxed, but Not Currently)
A story will help me describe the principle of deferred income. Jenny, an artist, earned between $30,000 and $40,000 each year selling her artwork to local retailers. One year she was faced with a “good” problem: a national wholesaler discovered her work and bought her entire collection for $200,000—just in time to distribute it for the Christmas season. Though the unexpected income was exciting for Jenny, she feared the looming tax consequences of being thrust into a much higher tax bracket from the sale. With this new income she would be making a lot less money per item sold, from an after-tax perspective, because she would be in a higher bracket.
As she put her mind to work on this problem she came up with a creative solution to reduce her tax bill—or to at least delay it: she would wait until January to cash the wholesaler’s check. That way the money would not show up as income until the following year, giving her a lot more time to figure out how to reduce her taxes, or at least more time to pay them.
There was only one problem with Jenny’s idea—it wouldn’t work. Many people have tried to do exactly as Jenny had planned, but the IRS does not allow the postponement of tax payments based solely upon the timing of cashing a check. However, the strategy of delaying (or deferring) income is allowed when done the right way. In fact, tax deferral is a principal technique that tax writers use as a means to encourage desired behaviors. Some of the opportunities that are available for deferral of taxable income include:
· Earned income diverted (contributed) into tax-qualified retirement accounts (such as IRAs, 401(k)s, etc.)
· Gains on investments within tax-qualified retirement, education, and health savings accounts
· Gains on investments within annuities, life insurance products, and pensions
· Exchanges of investment properties, such as selling a rental house and buying another with the proceeds
· Livestock reproduction and farming (deferred until sold, or tax-free when you use it personally)
There are two main benefits derived from income deferral. First, it allows the income to remain invested (whereas part of it would have otherwise gone to taxes), leaving more money available for additional growth. Second, deferral provides an opportunity to lower the rate at which your income is taxed, assuming that your future marginal tax rates are lower (when you use the money) than your current rates (when you earned the money).
You should consider some potentially negative factors when deferring income. First, when you defer income you are usually agreeing to rules that govern that deferral. This means that you must use the money only in certain ways or at certain times, as stipulated in the tax code (such as for education, or after reaching retirement age). If you act contrary to these rules you are penalized with extra taxes (discussed in the “Penalized Income” section below).
Second, in the case of some tax-deferred accounts, growth in the account is taxed at ordinary income tax rates (instead of the capital gains rates normally associated with investments) when the money is withdrawn—bringing the potential for a much higher tax rate on the growth of the investments if they were not in a deferred account. Third, the deferral can backfire on you if the tax laws change and the rates increase during the deferral period—causing you to pay higher taxes than you would had you not deferred the income.
Tax deferral is one of the most commonly used tax planning strategies. Understanding the rules that govern the different types of deferrals will help you determine whether a particular strategy is right for you.
Potentially or Partially Taxed Income (Including Social Security)
On one occasion I was asked to analyze an elderly couple’s tax situation. The wife was considering going to work part-time to supplement their lifestyle. They were concerned that they would be losing most of what she earned to new taxes, due to the special rules that determine the taxation of Social Security income. It turned out that their fears were justified.
Social Security income falls into the “potentially or partially taxed” category. This category refers to income sources that are taxed only when certain conditions are met. The amount of tax levied on these “potentially or partially taxed” income sources is variable. The tax is determined by a formula that takes into account your total income (including tax-free sources), the deductions you have claimed, and the amount of each type of income you have received. The formula then dictates whether the income will be taxed, and to what extent. Common “potentially or partially taxed” income sources are:
· Social Security benefits
· State tax refunds
· Sale of a home
Of these income sources, Social Security income is of particular interest because it affects so many people and because it is a particularly nasty kind of “potential or partial” tax. Once your total income rises above a certain (minimal) level, part of your Social Security income can start to be taxed—with a maximum of 85% of it being taxed when your total income reaches certain levels. The nastiest part of this tax is that you are double-taxed on the new income. You are charged income and payroll taxes on every new dollar earned and you’re also taxed on a new part of your Social Security income that would not have been taxed otherwise.
The irony of this is that Social Security income theoretically comes from the taxes that you paid throughout your working career—you are being taxed on the taxes that you previously paid (even though you didn’t get a deduction when you paid them). Social Security Income taxation is covered in much greater detail in Chapter 7.
Penalized Income (Higher Than Normal Tax Rates)
When it comes to using the tax code as a means to manipulate behavior, there are certain behaviors that are clearly discouraged by lawmakers. In regard to income, the most common behavior that is discouraged by tax writers is using money contributed to tax-qualified accounts for reasons outside their intended purpose. Examples of this would include withdrawing money from an IRA or 401(k) before you are 59½ years old or using money in a Health Savings Account (HSA) for over-the-counter medicine. If you don’t use these special accounts in the way that the government deems acceptable, the tax code will punish you. Not only will you pay ordinary taxes on that income, but you will also pay an additional penalty tax. Some of the most common forms of penalized income include:
· Not withdrawing a minimum amount of money from tax-qualified retirement accounts after you reach the age of 70 ½ (50% penalty).
· Withdrawing funds from a tax-qualified retirement account before the requirements for age are met (10% penalty).
· Contributing more than is allowed to a tax-qualified retirement account. This penalty continues each year until the extra funds are withdrawn (6% penalty).
· Withdrawing funds from an education savings account for uses other than those specified in the code (10% penalty).
· Using money in an HSA account for items that are not allowed (20% penalty).
When deciding to establish a tax-qualified account, it is very important to first understand all of the rules that govern the account so that you don’t find yourself unknowingly crossing a line and owing a stiff penalty.
Earned and Unearned Income
Another important distinction between sources of income is whether the income is “earned” or “unearned.” In simple terms, earned income is received as a result of your own efforts, not from the efforts of others. If you are employed by a business, all of your income from that employment is considered “earned” income because you receive it for the service that you provide the company. If you own a business with employees and you also work in the business, some of your income is earned and some may be unearned, because some of the income can be attributed to your own efforts and some of it comes from the efforts of others. On the other hand, if you have ownership in a business in which you don’t work (such as owning the stock of a company in your investment account) and you receive income from that business (such as dividends), that income is unearned because you did not perform any personal service to receive the income.
This distinction between earned and unearned income is very important because it can significantly affect the amount of taxes you owe. Earned income is a type of ordinary income (taxed at the highest rates). On top of the ordinary income taxes, earned income is also subject to employment taxes (Social Security, Medicare, Unemployment, etc.). These additional taxes add a significant burden to the income that you “earn,” making it potentially the most costly income that you receive.
For business owners, the distinction between earned and unearned income can also be a factor in determining which type of business entity is chosen for the operation of the business (such as a corporation, a sole proprietorship, or a partnership). The proper entity choice may enable some of the profits from the business to be considered “unearned,” resulting in a lower tax on that income.
The distinction between earned and unearned income is often the largest factor in determining a person’s overall tax burden. It is a key place to focus when planning the way that you will earn (or un-earn ) your living.
Two sources of income fall into the “passive” category. The first is income received from rental activities and the second is income originating from a business in which you have ownership but do not “materially” participate (meaning you don’t really have any role in the operation of the business—only an ownership interest).
The importance of passive income is mainly in how the designation affects the treatment of losses. If you lose money in a business you can generally subtract those losses from other sources of income. However, if the business loss came from a passive source, you cannot offset other non-passive income with those losses—meaning the losses do you no good from a tax perspective (in the current year).
Example Shane has several sources of income. He is a computer programmer at a software company, he is trying his hand at a multilevel marketing business selling nutrition supplements, and he has an investment in a partnership where he contributed startup money but does not participate in the operations of the company. In the current year Shane earned an $80,000 salary from the software company, lost money in the nutrition business (spent $2,000 more than he made), and the partnership he invested in lost money as well (his portion of the loss was $5,000). On his tax return Shane can subtract the $2,000 loss in the nutrition business from his salary, reducing his total gross income to $78,000 ($80,000 salary – $2,000 business loss = $78,000). However, he cannot subtract the $5,000 loss in the partnership from his gross income because that income (or loss) is passive and can be subtracted only from other passive income (neither the salary nor nutrition business is passive). Even though there was a real loss of money in the partnership business, it will not help reduce Shane’s tax bill in that year.
This description gives you the basic concept of the limitations that are placed on passive income and the tax consequences of those limitations. Of course, there are exceptions to these rules (and exceptions to the exceptions). However, the key difference to remember is that passive losses can benefit your taxes in the current year only if you have other passive income to use them against.
Unleash the Power of Warren Buffet’s “Secret”
Now that you have an understanding of the various ways that income is taxed you are armed with great power in your personal tax planning. The great secret of wealthy taxpayers is conscious control of their sources of income. You can put a lot of effort into learning and implementing the myriad deductions and credits that are available—and by all means, you should. However, the reality is that in order to claim a deduction or credit, you must spend money. Worse yet, the money that you spend will always be more than the tax savings that you receive. Deductions and credits are great, but they should be used only for things that you would have spent money on regardless of the tax consequences.
On the other hand, changing your sources of income can dramatically reduce your tax burden without spending one dime. You could literally owe between $0 and $596 in taxes for $1,000 of income, depending on its source. Multiply that effect by all of the thousands of dollars of income you earn and you quickly conclude that using differences in taxation to your advantage will make a significant difference in your wealth over time.
Example It is not just the Buffet types who know and take advantage of this “secret.” Lawmakers who write the tax code know exactly what they are doing and personally take advantage of these different strategies as well.
Of course, I am not suggesting that you quit your highly taxed job today and try to live off of municipal bond interest in order to be tax-free. What I am suggesting is that you craft a personal strategy that builds tax-free and low-tax sources of income over time. Then, as those sources of income grow, you can wean yourself from the highly taxed sources of income. As you make these shifts in your income streams you will free yourself from the significant burden that the tax code places on our less informed citizens.