On Taxes
The first rule of taxes is to not pay too much attention to them.
Taxes feel burdensome, high, and un-fun, but they are never the most important determinant of your wealth or poverty. Consequently, taxes should never be the primary reason for making a financial or personal decision.
A simple test in investing, or deciding where to live, or how to run your business, is this: Are you doing it “because of the taxes?” If you answer yes, you are doing it wrong. Taxes are the tail, not the dog. Don’t let the tail wag the dog.
You will hear people pitch investments as advantageous “because of the tax loss” like that’s some kind of sophisticated approach to money. Investing in loss-making things is not a way to build wealth. Some people justify their overly large mortgage as clever “because I need the tax deduction,” which seems like a great way to remain overindebted for life. Some people decide where to live “because of the taxes,” which seems as sensible as booking a 5-hour flight across country in order to use the plane’s in-flight Wi-Fi. While you should not ignore the effect of taxes on your wealth, you should never justify dumb financial decisions “because of the taxes.”
Having said that taxes are the tail, not the dog, being financially savvy means knowing something about how taxes affect us financially. Throughout this book, I mention specific tax advantages of a variety of activities, like retirement savings and investments (Chapter 9), buying houses (Chapter 12), estate planning (Chapter 19), entrepreneurship (Chapter 21), and philanthropy (Chapter 21).
But while those tax tips apply to specific situations, two big-picture tax principles deserve their own chapter, this one. These principles are not “tax tips” as much as they are fundamental and somewhat hidden ways to understand the role of taxes as guardrails on our financial life.
The first point is that income taxes, properly understood, provide a key incentive to saving money. Second, income tax policy in the United States, properly understood, suggests to us something profound about “how to work.”
Taxes and Saving Money
On the topic of saving money, taxes are the reason why not only is “a penny saved is a penny got,” but also 75 cents saved is equal to a dollar earned. What do I mean by that?
Let’s start here: the two basic ways to have more money in the bank are first to earn more, and second, to spend less. A math nerd might express these two ways as:
A. 2 plus 1 equals 3 (earn more), or
B. 2 minus negative 1 equals 3 (spend less)
Taking away an expense, also known as not spending money, gets you that awkwardly phrased “minus negative 1.” You recall from your middle school math class that “minus a negative” mathematically is the same as adding a positive.
Anyhoo. The point I’m leading up to is that these equivalent math things are not treated the same by income tax policy. Earning money gets taxed. Saving money does not get taxed.
Further, I mean that, in order to put $1 in your bank account, you generally have to earn more than a dollar to obtain it, because the government will take its cut of your earnings, in the form of income taxes. On a larger scale, if you want another $25,000 in your bank account, and you’re taxed at a 25% marginal income tax rate, you’ll need to earn wages equal to $33,333. With those wages, after you send Uncle Sam his $8,333, you’ll have your $25,000. That’s a relatively hard way to increase your net worth by $25,000.
By contrast, you can keep an extra $1 in your bank, or $25,000 in your bank, by not spending your money. The choice to not purchase the $1 candy bar at the checkout counter, or to not purchase the $25,000 car at the sales lot, leaves that much cash in your account without paying any taxes on it.
Because of the way taxes affect earnings versus savings, modesty in our consumption—whether candy bars or cars—will keep us on the side of tax efficiency.
Because of taxes, a penny saved is quite a bit more than a penny earned. Saving money is always more tax efficient than earning money. Just something to keep in mind.
Understanding the hidden role of income tax policy could influence how you approach the world of work and earning money. Income tax policy in the United States is famously complicated, but I’m going to explain it in simpler terms than I’ve ever seen it explained anywhere else. Are you ready?
But first, a trigger warning. Depending on your financial situation and political views, this next bit could make you feel queasy. That’s OK. The discomfort is normal. Stick with me for a moment.
The U.S. income tax code currently tells us that we as a society reward inheritance the most, followed by living off your pile of wealth next, followed by actually laboring for a living. For most of us, we aren’t working in line with the way tax policy is written.
If you inherit money, as of this writing, the first 11.2 million dollars comes tax-free. You owe the government nothing. Under current policy, if you inherit more than roughly 11 million (or 22.4 million if both your parents pass away), then the additional inherited money will be taxed at 40%. What that says to me, and maybe to you, is that the best way to get wealthy in America is to be born into the right family. By “best way” I mean that tax policy rewards children of the very wealthy—at least up to the first 11.2 million—by not taxing their money.
We can debate whether that’s “fair” or not. What is clear to me, however, is that tax law rewards inheritance as the single best way to get rich. Perhaps needless to say, this isn’t the way the American Dream is typically presented by the Financial Infotainment Industrial Complex. If you think about it too hard, you might get a tad skeptical of the American Dream.
The next best way to get money is by earning interest on municipal bonds, which are typically exempt from federal, state, and city income taxes. If you have $100 million in municipal bonds and you can earn 1% per year on those bonds, you can have that income, that $1 million in annual interest, tax-free. So that’s nice, assuming you’re already ultra-wealthy.
The third best way to get money, according to the tax code, is from owning businesses that regularly distribute profits in the form of dividends. Dividends are only taxed at 15%, as of this writing, lower than almost anyone earning a living through work, or 20% if you earn a substantial income. What that tells me, and should indicate to you, is that owning a business—or a group of businesses through the stock market, for example—is the next best way to “earn” a living. The tax system rewards wealthy capitalists who can live off their pile of money.
The fourth best way to get money is through long-term capital gains, meaning earning money by buying and selling a stock or business that you’ve owned for more than a year. If you do this, you will only be taxed at 15%, or 20% if you’re in the highest tax bracket. What that tells me, and should tell you, is that the government prefers you to be a wealthy capitalist and earn money through your investment portfolio, rather than through traditional salaried labor. Are you getting the picture yet?
The fifth, and “worst way” to get money, according to the tax code, is to actually work for a living and get paid for that work. If you earn a salary from your employer you will pay, as of this writing, up to 37% on your wages. This tells me, and should indicate to you, that the tax code discourages you from working for your daily bread. Sadly, this is what most of us do. And it’s quite taxing.
Again, it’s far better, the tax code seems to indicate, to be born wealthy or to live off your pile of investments than to do any work. And again, this is a bit of a departure from the way the Financial Infotainment Industrial Complex presents the American Dream of hard work, discipline, and wealth building.
Hey, don’t shoot the messenger. I’m just here decoding tax rates for you.
When I first realized all of this, I’ll admit I was kind of upset. Like, that’s not fair to the 99% of people who actually, you know, don’t have a huge pile of money to keep them clothed and fed. It’s not fair to working stiffs who have to go to work every day, rather than just collect tax-advantaged dividends and capital gains, especially on their tax-advantaged pile of inherited money.
I mean, how could the world develop in such an unfair way? Somebody should let the people who write the tax code know what they’ve done!
Well, Virginia, can you make a wild guess who really writes tax laws in the United States? Also, there is no Santa Claus. We’re having this little adult chat because it’s enough to make me, or maybe you, think about the injustice of it all. But let’s calm down together and make a plan.
Because as my close personal friend GI Joe was fond of saying, knowing is half the battle. If you want to orient yourself most efficiently within the constraints of the tax code as it’s currently written, you should consider the value of building up an investment portfolio. You should aspire to put aside money for purchasing assets to provide your income, which will allow you to be taxed at a lower rate than regular working people. You should think about how best to move from earning money as “labor”—taxed at the highest rates, and instead earn money as a “capitalist”—taxed at the lowest rates in our system.
Optimistically speaking, can you move, even if it takes you a slow lifetime, from someone who earns money in a high-tax way—through work—to someone who earns money in a lower-tax way—through investments?
You can bemoan the fundamental unfairness of the tax code. But in the meantime you should also orient yourself to take advantage of it, when and if you can.
Finally, a single word (OK, a contraction of two words) about doing your own taxes: don’t.
If you have a job and earn more than a few thousand dollars per year, you can’t afford to do your own taxes. A good tax professional will save you time, money, and the risk of running afoul of the IRS.