The more you make, the more money you pay in taxes, right? Not exactly. As you may have heard, many of the wealthiest Americans have found ways to be proactive with tax planning to minimize the taxes they owe & in some cases, completely eliminate them. They have been using these completely legal tax planning strategies to reduce their tax burden for decades. In this article, we discuss five tax minimizing strategies and why they are key to building long-term wealth.
1. They Hire A Tax Strategist.
A wise CPA once told me, it’s not about what you make, it’s about what you keep. Unfortunately, not all CPAs are created equal. There is a big difference between an accountant who prepares your tax return and one who actively works with you on tax strategies. For the wealthy, tax planning is not something done at the end of the year or during tax season, it’s something they consider throughout the year. Hiring a CPA who will work with you on implementing tax strategies to reduce your overall tax burden is critical to growing your wealth.
Different forms of income are treated differently by the IRS. Whether you earn a paycheck, are self-employed or a business owner, make money from investments, or retirement income like an annuity, social security, pension, or withdrawals from a retirement plans – each of your income streams may be subject to different tax rules and regulations. As such, there are fundamental differences in strategies to employ depending on your source(s) of income. For example, if you are a salaried employee, the optimal way to reduce your tax burden is through your investing strategies, discussed in more detail below. Wealthy high-income earners use their investments to reduce their tax burden, given there is less opportunities via your salaried earnings. If you are a business owner, the tax code provides several incentives to reduce your tax liability through both your business and investing strategies. A good tax strategist will be able to walk you through these differences in approach and discuss recommendations based on your circumstances.
2. They Diversify Their Investments To Include Tax-Advantaged Assets.
There’s been a lot of discussion lately on how some of the wealthiest Americans, pay some of the lowest amount of tax on their earnings (think Warren Buffet, Elon Musk, former President Donald Trump). The best way to understand how this is possible is by looking at their tax returns and what type of assets they invest in. One such strategy used to reduce their tax liability is to invest in assets that benefit from the most powerful tool within the IRS code, depreciation. Think of depreciation as the decrease in the value of an asset over time. One example of depreciation is the value of your car decreasing as soon as you drive it off the lot. Real estate is one type of investment that benefits from the power of depreciation. The value of real estate increases (appreciates) over time but the tax basis is decreasing as the property depreciates. Additionally, as you earn cash returns (i.e. in the form of distributions), the tax on the amount you receive is deferred, meaning your tax on those earnings are offset by the paper losses from depreciation until it’s sold. The beauty of investing in assets like real estate is that your investments lower your tax obligation rather than increase it, unlike some other investment vehicles, such as stocks and mutual funds.
3. They Take Advantage Of Deductible Expenses.
The tax code provides multiple opportunities for business owners to reduce their tax burden. Unfortunately, many of these strategies are not available to salaried employees. The IRS does incentivize business owners largely because you are creating jobs and stimulating the economy. There are several tax deductions business owners can legally take to reduce your business’ taxable income, thereby saving you a significant amount of money on your quarterly and annual tax burden. Keep in mind the key to implementing these strategies is maintaining details and documents to support these items.
Some of the most overlooked strategies include:
– Vehicle usage for your business,
-Vacations/travel costs when you spend more than half of your time on business,
-Employing your children in your business to shift income (first $12,000 is tax free and any remainder would be taxed at a lower rate than your ordinary income),
-Business meals (100% deduction for 2022 tax year, reverting back to 50% in 2023),
-Home office deductions (including the write-off/depreciation for any furniture and equipment),
-Giving a portion of your business to children & family, you can reduce the overall tax burden for you personally and take advantage of lower tax brackets
-Health insurance for the self-employed
4. They Understand The Difference Between Good Debt & Bad Debt.
Just as not all CPAs are created equal, neither are all types of debt. Most of us have been taught our whole life that borrowing money is something done only out of necessity, to purchase a car or a home for example. Bad debt can harm your credit and deplete your earnings. Credit card debt is one of the most common examples of bad debt. Good debt, on the other hand, is borrowing that helps you build long-term wealth. In ProPublica’s study into billionaires’ tax returns, one of the most powerful strategies used by the wealthy was the use of good debt as a means to supercharge their investments and grow tax-free wealth. When you sell off your stock or other investments for cash, you pay capital gains tax on the sale from those investments. Instead of selling investments, the wealthy will strategically leverage their assets as collateral and borrow against them, rather than sell them off for cash and incurring capital gains. The reason why is very simple, you do not pay tax on borrowings, only on gains and income. This scenario actually creates a double tax benefit in that you are not on the hook to pay capital gains tax from selling your assets AND the loan proceeds are not considered taxable income. You can use your new borrowing to pay for new investments and multiply your wealth. This allows them to keep their tax bills low, continue to benefit from the appreciation of their invested assets, plus increase their net worth with the additional investments made with loan proceeds. Some tools used to accomplish this are HELOCs, cash value life insurance, credit lines, and self-directed IRAs. They will use loan proceeds from these tools to buy assets that will appreciate in value on a tax-deferred basis and create passive income.
Admittedly, this strategy is not for the faint of heart and should be implemented by investors who want to think bigger to compound their wealth but do so safely. Additionally, before you implement, you should know the key factors to adopting this strategy. The first is that you must reinvest your loan proceeds in assets that return more than the interest rate of the borrowing. The second consideration is to ensure you are investing your proceeds conservatively and in assets with less volatility. My motto has always been to use this strategy to invest in what I know and feel comfortable with to avoid unwanted risk. I have been able to execute twice as many investments by using these strategies than if I hadn’t.
5. They Max Out Retirement Savings Accounts.
One of the most frequently used tax-minimization strategies by the wealthy that is available to people of all income levels is contributing the maximum amount to their retirement accounts. With qualified retirement plans come tax benefits. Employer-sponsored 401(k) (limit ($22,500 2023 401k limit and an additional $7,500 if you are over the age of 50) are funded with “pre-tax” dollars thereby decreasing your taxable wages. Plus, if your employer matches your contribution, that’s a great source of free money. Depending on your income level, maximizing your 401(k) may not be feasible so be sure to consider any short-term needs given the early withdrawal penalties and market volatility. Contributions to plans like the SEP IRA, used by self-employed workers and small-business owners ($66,000 limit for 2023) or an IRA plan ($6,500 limit for 2023 or $7,500 if you are over the age of 50) are tax-deductible. With these plans, you will also have more investment options available, particularly with a self-directed IRA plan. The more you can save for retirement in qualified retirement plans, the larger tax benefit you’ll see.
The Bottom Line
When you consider taxes are the largest expense we bear as Americans, it becomes clear the fastest way to put more money back into your pocket is through reducing your tax bill. There are different tools available based on your various forms of income. Your wages and investments can help you build wealth, but taxes can take a significant bite out of your earnings if you’re not proactive. It’s critical to employ tax savings strategies if you want to maximize your earnings’ potential and build long-term wealth.