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Low Income, High Net Worth: The Best of Both Worlds

20131025_125301In the United States, and I suspect in most countries around the world, people are taxed for spending and rewarded for saving. Almost all the tax revenue raised by the federal government comes from spending. This idea taxes are too high or the rich get a better deal is false because the middle class has the best deal going for it than at any time in history.

The reason taxes are so high for many people is they spend too fucking much money! In America, for example, the taxes levied against spending are massive while savers and investors are rewarded with low or even negative tax rates. This constant complaint of taxes being too high is annoying at best. Taxes are not too high when the people complaining about them volunteer to keep paying them. Here are a few of the extra taxes you pay when you spend: sales and use tax, property tax, excise tax, and corporate tax. Yes, corporate tax! Do you think businesses don’t pass all their expenses on to the buyers of their goods and services? Of course they do. And you pony up with a million dollar smile (when you are broke) and pay all those extra taxes and complain about how high taxes are.

The income tax return is also built around people dumb enough to spend like drunken sailors (no offense to sailors who drink responsibly). You do realize there is a Saver’s Credit on the tax return? And don’t get me started on the benefits of retirement accounts. You even get to choose between a tax deduction now or tax-free income later. People with a Health Savings Account get both a tax deduction and tax-free growth.

I don’t want to whine all day on this (okay, I could whine all day on this) so I will only focus on the more generally topics in this field worth whining about. The small amount of information in this short post can easily cut your income taxes in half and more than half in other taxes. Anyone with an income under $100,000 can structure their finances to pay no income taxes in the U.S. Okay, you might have some income tax; it should add up to about 1% to 3% of your income. But if you are serious you can get a negative tax rate too.

Non-Income Taxes

I’m fired up so sit back and enjoy the rant. People endlessly hound me over how high their taxes are. NO THEY ARE NOT! Your taxes are high due to YOUR behavior, not the tax bracket. Warren Buffet says the tax code is broken because his secretary pays a higher tax rate than he does when he is one of the richest people alive. Bullshit! Warren Buffett has a smaller tax rate than his secretary because he spent less of his income and invested it, where the tax rate is really low and in most cases not taxed at all.

Smokers pay a massive tax rate because the excise tax on cigarettes is tremendously high. Driving a gas guzzler which also costs a lot more than a fuel efficient vehicle has a federal and state excise tax attached to each fill-up. Groceries, medical, and housing is generally exempt from sales taxes, but is applied to purchases of stupid shit. Personal property is taxed in some states and real estate taxes are in every state. Even renters pay property taxes when they pay their landlord. If the landlord did not pass the expense to the tenant she would soon be bankrupt and the new owner would certainly know enough to raise the rent to cover all expenses. The smaller your home, the smaller the tax.

I’m not saying all non-income taxes can be avoided. I tip a glass now and again and understand there are excise taxes on alcohol. I make more of my own hooch than I buy however, eliminating most of the excise taxes paid. If you smoke, stop! Not only will you live longer, you will have money to enjoy that longer life. You also know they have one of these fancy devices called a—ah, what is that called again?—oh yes, a bicycle. They have been around a while. They worked out all the bugs found in the beta version. I will be the last guy to tell you to never drive, but gawd people, trips less than five miles are made for walking and biking. And with every step and with every turn of the peddle you are telling the government to go fly a kite!

Sales tax is the ultimate kick to the crotch. The more you spend on stuff you don’t need the more you pay. Isn’t that nice? The government can spot a sucker from across the continent and has no problem unloading a fool’s wallet. “More stuff” is the battle cry of the oppressed, sorry, obsessive spender crying taxes are killing them. Do you have any idea how much those tax dollars would accumulate to if they were invested instead of paying taxes? And since you chose to pay that extra tax just so you can have more shit to store, insure, and protect, it is an easy tax to avoid.

Income Taxes

Now we get to my favorite game: reducing income taxes. The goal: zero. Yes, your favorite accountant loves finding ways to reduce the income tax bite. It is easier than you think. I sometimes give presentations showing how I can take a $100,000 income based solely on wages and drop the income tax to zero. It’s a fun game. The best part is that in year two you not only have a $100,000 wage, you also get a tax-free $5,000 bonus (unrealized market gains or retirement plan profits from prior year investments).

Let’s run down some of the goodies available on the income tax return. Most people get personal exemptions and a standard deduction. Sure, you can itemize, but that is for losers (unless you itemize due to charitable giving). Itemizers think they are getting a tax break because they deducted the $22,000 in mortgage interest they sent to the bank and the $12,000 in property taxes they paid to the local municipality. Stupid! If you want to give $36,000 away so you can get a quarter of it back on your income tax return I have a better idea. Build a structured charity plan. Better yet, deduct contributions to charity with a full deduction and don’t report it on Schedule A. Yes, I have a post in the queue on how to deduct donations to charity without itemizing. I call it structured giving.

Low income taxpayers qualify for a Saver’s Credit if they just friggin save! Can you imagine? The government slipping a quick thousand in cold hard cash to use any way you want just for tucking a bit of your income away instead of spending it? It’s true, I swear.

If your income is too high there is still a coterie of retirement plans available to drive your taxes to ground level. The facts and circumstances will determine which plans you need to implement for maximum results. Know this, a married couple in the right circumstances can tuck up to $106,000 into retirement accounts and deduct it from income.

IMAG0320Health Savings Accounts are the best of all worlds. You get a deduction for an expense that has not happened yet, but is required spending at certain times in life. The gains are all tax-free if used for qualified medical expenses. Healthy people can watch the account grow and grow only to use it to cover Medicare premiums when they reach 65. (HSAs cannot be used to pay health insurance premiums, except Medicare premiums.)

Rich people also know there are several forms of income that never get reported. Gains inside a retirement account either grow tax-free or tax deferred. Capital gains on investments are only taxed when realized. Investment property owners can defer the gain on the sale of a property with a 1031 exchange (like-kind exchange or sometimes called a Starker exchange). Dividends are taxed preferentially, too. Investment gains, dividends, interest income, and investment property profits all avoid the payroll tax.

As a departing gift to my friends I present one last nugget of knowledge sure to place a smile on your face.

The United States Internal Revenue Code has so many moving parts it is easy to manipulate to your advantage. The wealthy do it all day long. It pays better than working a job. The latest wrench tossed into the works is the Affordable Care Act. This has created more opportunity than any other piece of tax legislation.

Understand how the IRS handles credits or deductions. Most credits are on page two of Form 1040 and are non-refundable. This means you first have to owe a tax before the credit reduces it; credits greater than the tax liability are wasted. There are some refundable and partially refundable credits too.

We are familiar with itemizing where we can deduct state and local taxes, mortgage interest, and charitable contributions. Itemizing is the least valuable deduction because it can be phased out by income and most credits are calculated on income before itemized deductions (AGI).

The next higher level of deduction is between total income and adjusted gross income. Your AGI is figured by subtracting some expenses like student loan interest and retirement plan contributions from total income. Getting your AGI lower helps with some additional tax credits on your return.

But the Affordable Care Act premium tax credit is calculated using Modified AGI (see update below). This makes it hard to game the system. Total income is all the stuff on the top of page one of Form 1040. Wages, interest, dividends, capital gains, business income, and Social Security are all up there. If you get insurance from the exchange ( you can get a credit to use against your health insurance premiums if your income is less than 4 times the poverty rate. For a family of four your income approaches $100,000 before you no longer qualify for any credit at all.

The ACA premium tax credit is calculated using total income. Therefore, it is imperative to reduce your total income to maximize the credit. This means taking a retirement plan deduction at work is more valuable than taking it outside of work. The 401(k) deduction comes off your total income while a traditional IRA deduction comes off your adjusted gross income.

If you have a HSA qualified medical plan you also want to contribute to the Health Savings Account through a payroll deduction. Most people contribute to their HSA savings account on their own and get an adjustment to income. When the deduction is run through payroll it avoids all taxes and reduces your total income, meaning you will get a bigger premium tax credit.

Let me close with an example of how important it is to think outside the box on a tax return. The first year of the ACA I had a client who applied and took the maximum credit. He owed $12,000 on his tax return to repay the premium tax credit he was not due. The husband had retired, was on Social Security, but not yet 65. His wife still worked a job and received a W-2. To reduce the damage I recommended the following: contribute the maximum to a traditional IRA for the husband and wife. The husband was allowed a spousal IRA and the wife had adequate earned income to max out both IRAs.

Here is where it gets fun. The IRA deductions reduced AGI. The taxable portion of Social Security benefits is determined based on AGI, but the taxable portion of Social Security is part of total income. Follow carefully. The IRA deductions reduced AGI which lowered the taxable portion of Social Security which affects total income and increased the amount of premium tax credit qualified for. By understanding how the IRA deductions flowed through the tax return my client reduced their $12,000 balance due to $200. You read that right. A $12,000 contribution to traditional IRAs (the husband’s IRA max contribution was $6,500, the wife’s $5,500) reduced their taxes by $11,800! The funny part was they could take the money back out five minutes later and pay income tax on the withdrawal, but never would have to repay the premium tax credit.

It pays to understand how income, deductions, and credits flow through a tax return and the unexpected consequences of such actions. My client above had over a 98% tax rate on $12,000 of income all removed with a simple IRA contribution. Like I said, we tax spenders and reward savers. From now on you will save/invest half your gross income. I don’t want any excuses. You don’t get taxed on your net worth or even your income; your get taxed on spending.

Update: Thanks to an email from Charles C for pointing out the Premium Tax Credit is based upon Modified AGI. I always run the risk when I am thinking of a specific account and how it worked through the tax return. I got it wrong. The Premium Tax Credit uses Modified AGI which is AGI for most people, just not my client in this case. I made a slight change to the text above, but retained most of the wording and added this note.

Gaming the Earned Income Credit | The Wealthy Accountant

Saturday 26th of January 2019

[…] The great thing about saving half your income is the IRS pays you so much back in credits and reduced taxes that it doesn’t really hit your cash flow 50%. A small amount of self control goes a long way in building a massive net worth. […]


Monday 25th of September 2017

Like Sam, I am looking for ways to lower my taxes on 200k income but we don't own a business. We have 2 wages + military retirement , youngest child finishing college, no mortgage or other debt, not eligible for HSA, doing over 50 catch up and back door Roth conversion, and saving on top of that. Do you happen to know of any articles that you could point me to? Thank you, Lu

Financial Samurai

Tuesday 13th of December 2016

Ahhh, how I love, love this topic. I've been trying to teach my readers to build wealth more than income for a long time now. I think they get it with the examples of multi-millionaires getting healthcare subsidies and free tuition, but I'm not sure.

But I'm having a really difficult time figuring out how to get my income below Trump's tax hike of $112,500/singles and $225,000/married.

Let's say you having operating profits before taxes of $500,000 from your S-Corp. How the heck can you get it to 0 after maxing out your solo-401k of $53,000? Given this is operating profits, this is after all business expenses.



Keith Schroeder

Tuesday 13th of December 2016

Loaded question, Sam. There are several ways, but all would take a long time to flesh out. Also, before worrying about "Trump's tax hike", it first has to happen. I'll take a wait and see attitude before making a move. Also, the goal is not to get to zero, but to the zero percent tax bracket, which means you can have some income.

Let me whet your appetite before signing off. You have a $500k profit business. Consider the sale/leaseback or straight lease on new equipment. If the lease is a $1 buy-out at the end you can deduct the entire amount up front as you would any asset. Think about the possibilities. Then we can work on the rest of the income.

Jen G

Tuesday 8th of November 2016

" Know this, a married couple in the right circumstances can tuck up to $106,000 into retirement accounts and deduct it from income." How do you get to $106k 18k each 401 5.5k each Roth What am I missing?

New to blog sorry if this was covered somewhere else need to read more of you posts

Keith Schroeder

Tuesday 8th of November 2016

Jen, the max allowed into all retirement accounts combined (including employer contributions) for an individual is $53,000 ($58,000 for 50 and older). I'll need to do another post showing how you can reach this lofty goal. It takes a business and a higher income to qualify for this level of retirement plan contribution. For older people a defined benefit plan in their business can supercharge their retirement plan. There are a lot more posts to write. Time. It takes time. I'll get there.


Friday 28th of October 2016

Ok, so how can my wife and I pay no taxes? :) I get paid through W-2, wife is a Nanny. Mortgage interest, Property Taxes, 401k (for me), 2 Traditional IRAs, 2 HSAs. Still end up with a tax liability.

Keith Schroeder

Tuesday 8th of November 2016

Depending on the facts and circumstances, it is possible to reduce to zero, or near zero, your tax liability until your income exceeds $100k. Even with a higher income it is possible to reduce income to zero, but much harder if income if from wages or a business.