Tax season can spur a wide range of emotions. We’ve encountered this firsthand with our clients, and know how daunting it may seem when it comes time to pay your tax bill. We believe that it is more advantageous for you to pay your taxes now rather than opting for deductions or facing future tax payments later. While there are strategies that can reduce your tax burden, it’s crucial for you to focus on increasing your income rather than spending excessive time and energy on thinking of ways to minimize your taxes. Social media paints a half-truth picture about how wealthy individuals avoid paying taxes, and while some of these claims hold true, it is unrealistic to completely eliminate your tax obligations if you’re making money from your business.
Let’s establish a foundational understanding of how to build wealth in a way that enables you to reduce your tax liability both now and in your retirement years.
Three Types of Income
There are three different types of income, each with their own specific rules, deductions, and strategies. Some types of income are more advantageous than others when it comes to reducing your taxes.
We categorize your income into three groups:
- Earned income (ordinary income). This is the money you earn from working, whether it’s from your job (W2 income) or from your own business. Earned income is subject to the highest level of taxes. If you have a business, you’ll have to pay self-employment tax on your business income. If you have a job, you’ll have to pay payroll tax, which includes social security and Medicare tax, on your W2 income.Earned income also includes things like retirement distributions or pension income, although unlike W2 and business income, if you contribute to a traditional 401K and withdraw funds during retirement, it will be subject to income tax but not employment or payroll taxes. This means it may be subject to higher income tax rates, but you won’t have to pay the self-employment payroll tax.The net profit from your business also falls under this category. Business income has lots of tax advantages, because the tax code allows you to deduct your reasonable business expenses against the income you earn.
- Passive/investment income. This type of income is usually taxed at lower rates. Rental real estate and capital gains on investments fall under this category. To illustrate, if you purchase and sell assets with the intention of investing, and hold onto them for an extended period of time, they will be subject to capital gains taxes, which are lower than ordinary income tax rates. This distinction arises because investments are treated separately from earned or ordinary income.The government implements lower tax rates on certain investments to encourage people to invest and stimulate the economy. These tax breaks are not loopholes, but intentional incentives designed to motivate individuals to take advantage of them by starting businesses or making investments, thereby supporting and boosting the overall economy.For example, if you invest in rental real estate and handle it correctly, your earnings can be tax-free after you claim depreciation deductions on the real estate, which can offset any cashflow you receive from the rental income.
- Tax-free income. This is the best type of income because individuals can enjoy income without any tax obligations. Tax-free options can include distributions from Roth retirement accounts, such as a Roth IRA or a Roth Solo 401k. If you have a 401k through your job or your business, you may be able to set up a Roth option for tax-free distributions in retirement. With a Roth account, you won’t receive a tax deduction for the money you contribute now, but you will enjoy tax-free distributions when you withdraw the money during retirement.
Income sources that help you work smarter, not harder
Did you know that real estate may provide you with tax-free income? One way to cash out of the real estate you own is by taking advantage of the increased value of your property. Instead of selling the property to pull out your equity you may be able to execute a cash-out refinance, where you obtain a loan against the property and receive tax-free income for the equity you have in the property. This allows you to benefit from the appreciation of the real estate without having to pay any taxes on the income you receive.
Another way to take advantage of depreciation can be to acquire a business. When you acquire the assets of a business, you will typically be able to take accelerated depreciation for any physical assets you acquire – even if you take out a loan to fund the purchase (up to certain limitations). This depreciation can offset the income you earn in the business, reducing your tax burden.
Another option to consider is a life insurance retirement plan. This unique plan allows you to use life insurance as a means of saving for retirement. You contribute money to the plan and it gets invested, typically earning a return of around four to five percent. The best part is that you don’t have to wait until retirement age to start accessing the funds. You can withdraw the money and enjoy tax-free income whenever you need it. This tax-free income can be a valuable asset in your financial strategy, providing you with flexibility and security for your retirement years.
Now that you have a clear understanding of the various types of income, such as earned income, passive or investment income, and tax-free income, it’s important to address the question of paying taxes. Many clients wonder how they can minimize their tax payments, and our response typically revolves around the idea of earning better income. If your tax return shows that all your income falls under the earned category, you will be subjected to higher rates.
Check out our next blog on how to pay less in taxes, start investing and reduce your earned income!
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