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Tax Control—the Master Ingredient to Wealth
Do you feel like your wealth’s being taxed to death? Making plenty of money but not keeping enough? High taxes can be one of the biggest obstacles preventing you from building wealth faster. With taxes, it’s not who you know but what you know (and there’s a lot to know!). There are many tax advisors, but many barely scratch the surface, and quality tax advice can be remarkably elusive. That’s no surprise since studies have shown even IRS employees only understand between 55% and 83% of basic tax facts. Many people feel that their tax advisor is not proactive or knowledgeable or strategic enough, but truly sophisticated tax advice can mean the difference between treading water and getting rich.
Tax control is truly the master wealth ingredient. It’s not what you make, but what you keep that counts, and for too many people, taxes are a hidden siphon draining wealth year after year, which prevents your kitty from really ever filling up. Those that have access to best tax practices build wealth amazingly faster than those that don’t.
The concepts you’re about to learn about in The 9 Biggest Tax Mistakes and How To Avoid Them may help you get richer faster, retire years earlier, have more to spend in retirement, and really accelerate your wealth objectives.
Tax Mistake #1—Believing the Tax Code Is Set in Stone
The Internal Revenue Code is one of the most complex, convoluted, and internally contradictory documents ever created—and it keeps changing almost by the week. Various studies conclude that even IRS employees only understand between 55% and 83% of basic tax facts. As of 2006, the Federal tax rules totaled over 13,000 pages—and the rules have grown more complex since. Many of these rules exist to try to counter the tax reduction strategies that the most proactive taxpayers (and their advisors) keep coming up with to legally keep wealth in their families’ pockets, instead of the IRS’s. But for IRS, it can be a game of catch up, with the best advisors finding new opportunities faster than IRS can close old ones. Great complexity can breed great opportunity, and it’s been said that “sophisticated taxpayers take advantage of the complexity to find loopholes that lower their tax liability.” Tax avoidance is perfectly legal, and often remarkably easy, if you know where to look.
Too many taxpayers (and their tax advisors) believe in “death and taxes” inevitably, that you “gotta pay what you gotta pay.” The truth is, it is perfectly legitimate to use the portions of the tax code that support the reasonable position that results in the least tax—or no tax at all! This is a key concept; tax liability is a function of code interpretation, and astute advisors mine the complexity of the code to build the most favorable positions for taxpayer clients.
The opportunities to legitimately save enormous dollars can be profound, if you know where to look. Unfortunately, some tax preparation professionals may not be the right place. According to a Money magazine study cited in an MIT book, not one tax prep professional was able to produce a correct return! Often, even the most basic tactics, like controlling taxable investment income, or maximizing tax deductions, are completely missed. Good tax advisors are worth their weight in gold, but can be very hard to find, especially if you don’t know how to tell the difference.
If you own a business, are a high income professional, or have significant investment accounts (whether you are retired or not), you may be leaving way too much money on the table, and this report may be worth a lot of money to you. I hope it is!
Tax Mistake #2—Missing Tax Arbitrage Opportunities
Arbitrage just means taking advantage of different prices for the same thing in different markets. If you can buy gold for $1500/oz in London and sell it for $1700 in Dubai, you can make a riskless $200/oz—that’s arbitrage.
For instance, tax arbitrage—using the differences between tax rates applicable to different kinds of entities (C vs. S corporations, for instance) or different individuals (you and your children, for instance)—can save some people a real bundle. Another way to apply this concept is doing IRA ROTH conversions (paying the tax on the IRA in exchange for the remainder to grow tax free) in years when you are in a low tax bracket because you may have business losses, lost a job, or high deductions from medical expenses, for instance. Ditto for postponing IRA distributions until after retirement when earned income (and hence your tax bracket) is lower or absent. A great example of arbitrage is the so-called corporate inversion, a super “loophole” (now closed due to rules update as explained under Mistake #1) that basically let corporations swap high U.S. tax rates for near-zero ones in places like Ireland; this was perfectly legally under the law before it was changed—and still legal for the companies that had the foresight to seize the opportunity ahead of the curve.
Tax Mistake #3—Being an Employee Instead of Self-Employed
For those of you who can make this choice, being self-employed is a no-brainer. You can deduct a lot of legitimate expenses, set up your own deductible retirement plan, and use numerous, creative, complete above-board ways to cut taxes and build your own wealth more rapidly.
Shy of starting your own company, the independent contractor route is the most feasible for the average reader. Here, your pay is shown on a 1099 instead of a W2. The pay number on the 1099 is the beginning line on the business return you will file against which expenses are deducted to arrive at taxable income (a number usually much, much lower than where you wind up as an employee, even if you try to deduct the same items as “employee business expenses”). I won’t get into the technical detail here, but, trust me, the difference can be huge, as most CPAs will probably tell you. If you do this, you can file as a sole proprietor (using the Schedule C on your regular 1040 tax return) or actually set up a corporation or LLC (LLC is preferred—see my report on asset protection), and then file the appropriate business return (usually an 1120S, but possibly 1065), which dovetails into your personal return. While filing a business return can seem a bit of a bother (but is usually fairly simple and cheap), running your independent contractor work through your own company can yield many benefits, including asset protection and a much lower audit profile.
While I appreciate that many readers can not avail themselves of 1099 status without changing jobs, if there is any possibility at all, you should explore it. There are probably significant tax and other savings to your employer as well, so it is worth exploring with your owner, manager or HR. If the nature of your work meets the various IRS tests and can qualify, the wealth opportunity is significant for all concerned (except IRS, which is why it is not a fan of 1099 work!).
Tax Mistake #4—Not Using Real Estate Investment Tax Breaks
“Tax reform”, back in 1986, killed the real estate tax breaks so soundly that most of us don’t even remember how sweet they were anymore. Many taxpayers (and their advisors) incredibly still don’t know about the “real estate professional” loophole that opened up in the early 1990s, and that’s a darn shame for those of us that have amassed a bit of a real estate portfolio, whether business property, or commercial or residential rentals. In the right fact pattern—you have a spouse who has the time to spend, say 15 hours a week ostensibly looking after the real estate (keeping books, checking ads, painting or directing the painters, whatever) and is not doing much else occupationally—you get most of the old real estate write-offs back and can net them against your other income, possibly saving a huge slug of tax. If you have real estate besides your home, are frustrated by the post-1986 “passive loss” rules, and have a willing and able spouse, you really need to get a second opinion on this (TaxMaster™ has an endless supply of them).
And make no mistake, what you have heard about real estate investing being responsible for more millionaires in the U.S. is probably true. If you are careful, patient, and willing to spend some time, it can be a very effective and tax advantaged way to build wealth and ongoing income.
Tax Mistake #5—Not Maxing out Tax-Deductible Retirement Plans
This one’s pretty simple, and you probably know it even if you don’t do it. Money you contribute to a 401k, 403b, TSP, or other deductible plan at work comes right of the top of your gross income, meaning you save the income tax, and your share of the FICA (Social Security and Medicare) and other applicable taxes. FICA runs at around 7%, so if you are in a 25% income tax bracket, you save at least 32% right now (if in the highest 39.6% bracket, you save nearly 47%!). Do if you don’t contribute $10,000, you take home maybe $6,800. If you invest instead, the whole $10,000 goes to work for you. And while you will ultimately have to pay tax on withdrawals, you will benefit because:
- Chances are the savings discipline will make you wealthier down the road than not mending your earn-it and spend-it ways;
- You can use tax arbitrage as explained in Mistake #2 to sharply reduce or even eliminate the tax.
Tax Mistake #6—Not Planning around the AMT
The Alternative Minimum Tax has been around since 1970 and was designed as a way to force fat cats with smart advisors to pay at least some tax instead of avoiding it via the numerous complicated loopholes that existed at the time (of course, the smart guys just found other loopholes.) These days, it mostly ensnares middle income or higher income people who don’t (or whose advisors don’t) know enough or take the time to plan around it. All admit this is very unfair, but it continues because a) the tax code is broken and there is not the political gumption to fix it, and b) the Federal government spends far more than it takes in and really needs the money.
Increasing contributions to your deductible retirement plan, making investments more efficiency, and timing large, deductible items like property taxes into favorable years are a few ways to avoid this tax. There are a lot of other smart things you can do to plan around this tax, but the technical complexity of this particular nastily not-so-little tax precludes discussion here. Get the knowledge or find a really smart tax advisor, and most of all, plan before December 31—once the New Year’s ball drops, many planning options evaporate!
Tax Mistake #7—No Strategy or Ignoring Tax Efficient Investing Strategies
This is without question the most fundamental mistake made by taxpayers and their tax advisors/preparers. For some reason, this industry is almost hopelessly re-active. Most clients and preparers don’t even look at the fact patterns until after the first of the year, when nearly all potential strategies are impotent, except the old “well, you could put some more into your IRA.”
The reason this is so important is the tax “game” has four quarters and they all end on December 31st. After that, the score is mostly set in stone; it just is not visible until your preparer does the tax accounting.
In order to win the tax game, you need to play the game before it is over. Unlike the vast majority who don’t “plan” until after the end of the tax year, the smartest taxpayers and best tax advisors begin before the tax year begins, or at worst by summer of the tax year. Start planning much later than that, and even the best tax mind is a Monday morning quarterback.
As you accumulate wealth, taxes on investment returns become more and more important. Mutual funds with a lot of turnover are particularly tax inefficient since taxpayers are forced to pay tax on any gains or income the fund recognizes during the tax year, regardless of whether or not the investor themselves takes any income or recognized any gain. This has been widely viewed as unfair since implemented the late 1980s as part of tax reform, but widely ignored by taxpayers for decades, causing many to overpay. ETFs and single stocks are much more efficient in this regard. Deferred annuities are some of the most highly taxed products around—with really vicious LIFO and ordinary income tax treatment—but widely sold and swallowed as being tax shelters! Bond and CD income gets taxed at your highest bracket, but dividend income from stock sources enjoys a lower capital gains-type rate. Making stock changes at high market levels needlessly can exacerbate capital gains, and too many people still don’t do tax loss harvesting each year, which can save tens of thousands or more. All of the preceding has to do with non-qualified (non-IRA-like money), but there are lots of smart strategies for IRAs beyond the arbitrage discussed above. For instance, it is smart to put ordinary income rate (top marginal rate) assets like bonds in IRAs, but capital gains rate assets outside where they will enjoy the lower rate. Otherwise, in the worst cases, you can effectively pay about double the available tax rate! Worse yet, if the capital gains asset is one you might pass on at death, you may wind up paying the highest marginal rate instead of zero tax by way of the at death basis step up!
Tax Mistake #8—Not Planning an Estate Freeze
If your estate is likely to grow to taxable levels (right now over about $5.5M for individuals, including everything you own, which includes life insurance death benefits, but not so long ago it was only $600K, and with the fiscal situation, there’s no telling if it will stay as high as it is), everything over the exemption amount could be taxed at rates that start at 18% and got to 40% fast. An estate freeze caps the taxable value at current levels, limiting or eliminating tax. There are a lot of ways to do this, some much better than others, but many exposed taxpayers are never advised to prevent what could be a huge problem while there is still time. This oversight exists at all wealth levels. For instance, James Gandolfini (Tony from The Sopranos) left a $70M estate, and needlessly paid some $44M in estate taxes . . . and he had some elaborate (but maybe not so good) estate planning in place.
Tax Mistake #9—Not Using Tax-Free Vehicles, Like 529s and (Especially) ROTHS
Even for those who have develop advanced strategies to sharply reduce taxes from professional or business income and developed estate plans that allow significant wealth to pass tax free from generation to generation, basic tools like 529s and ROTHS can be extremely powerful. Though each has restrictions on free access, when used in accordance with the rules (which are actually pretty livable), their tax-free nature can really supercharge your wealth creation. To use a simple example, let’s say we invest $100,000 for 20 years at 10% net return. We will assume a blended tax rate of 30%, which is about halfway between the top income and long-term capital gains rates. In simple terms, a tax-free investment compounds at the full 10%, but the taxable one would only compound at 7% (10%-30% tax). In 20 years, the tax-free account is worth $672K, the taxable one is worth $386K (only about half a much). This is a super example of the power of tax control in building wealth. The difference in results is huge, but can be completely obscured unless you actually crunch the numbers!