"You don’t PAY taxes. They TAKE taxes. " ~Chris Rock
When you think about it, very simply there are only 3 things you can do with money. You can earn it; usually from a job but that money can also be earned from dividends, rent, capital gains, appreciation or distributions. But in some way, shape or form, money must first be earned.
After you earned it, it must be parked somewhere. Maybe it goes to your checking account or a savings account or maybe you keep it in hard cash.
Finally, after you have parked it, you will probably spend it. Food, rent, clothes, water, Netflix or a tropical vacation are just a few examples.
Any of these events can trigger tax consequences and not understanding those consequences can mean you pay MORE in taxes than you need to.
Let’s start with the first: earning money. Now as simple as this may seem, not all “earned” money is taxed the same way. In fact, according to the IRS there are three forms of income: Earned Income, Portfolio Income and Passive Income.
What is earned income? The IRS classifies earned income as income derived from wages, salaries, bonuses, commissions, tips, and net earnings from self-employment. If you get a W2 each year for taxes, you are earning earned income.
Now a bit of bad news: you will most likely NEVER become rich from ONLY earned income. It is taxed the most and you gain no leverage from it; there are only so many hours in a day and only so much you can make per hour before basic economics of supply and demand and elasticity take over.
Now technically speaking, there are 2 levels of earned income, but the IRS doesn’t really break it down like that. I will call them FICA income and NON-FICA income. As we mentioned before, earned income is the HIGHEST taxed income, at the time of this writing in 2020, in the United States the highest marginal tax rate is 37%, the lowest is 10% and there are 5 brackets in between there as well (nice the government keeps this simple, right?)
So, let’s just say you make $137,700 a year. Notwithstanding any state income taxes (the highest in California is 13.3% of your income) you will pay $24,295 in federal income taxes before any deductions or credits. If you are an employee, you just paid another 7.65% in FICA taxes or $10,534 more in taxes. Oh, and if you are self-employed, congratulations! You get to pay TWICE the amount of FICA taxes or now $21,068. So, if you live in an income tax free state, say South Dakota and are self-employed, 33% of your income goes right to taxes. If you are an employee, that drops to just over 25% of your income.
Now, remember what I called NON-FICA income? Well, this is income that can be taxed at your normal tax rates BUT is exempt from FICA taxes. Distribution income, dividend income, interest from notes and real estate crowdsourcing income would be examples of this. So, if you “earned” $137,700 of income from say Prosper, Peerstreet and Fundrise you would still pay $24,295 in federal income taxes but SAVE $10,534 in FICA taxes.
Portfolio income generally comes from the sale of assets such as stocks, bonds and real estate. Here, they are broken up into long term and short-term capital gains. Now with long-term as the name implies, you have owned the asset for “the long term”, in this case over one year. If you only owned the asset for a short term or LESS than a year, then short-term capital gains applies. Think of day traders of stocks and house flippers of real estate and you get the idea of when short term capital gains apply. Whereas the “buy and hold” strategy for either real estate or stocks would be subject to long-term capital gains.
As of 2020, the HIGHEST long-term capital gains tax is 20% and you must make over $441,451 annually if you file single, to hit that. If it is a short-term capital gain, then it is taxed at your ordinary income tax rate. So, let’s say you bought some stock in Tesla and then sold it and had it for over a year and made $137,700 in profit, you would pay JUST 15% in taxes or $20,655. Compared to your W2 income of the same amount you would pay $14,174 LESS in taxes.
Finally, there is passive income. Now many would consider passive income as income you are not working for or trading time for money. You do not have to go to work to collect dividend income, rental income, distribution income or interest income. But again, the IRS has a different definition of passive income: 1. Rentals, including both equipment and rental real estate, regardless of the level of participation or 2. Businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis.
So remember income from crowdfunding and P2P lending sites like Peerstreet and Fundrise (link fundrise.com/r/18yn8)? Well, the IRS does not view that as “passive” income (I know, it doesn’t make sense to me either). You will be taxed at your highest marginal rate for earned income. But if you own a rental property or are the owner of a syndication business that you get residual income from? Well, that would meet the IRS’ definition of passive income.
Just remember, earned income generally is taxed at the highest rate and comes usually from a job and offers no leverage as there are only 24 hours in a day.
Portfolio income generally is from the sale of assets for a profit. No FICA taxes, lower tax rates and only restrained by the number of assets you own and how much they increase in value.
And finally, passive income is taxed at the lowest rate and offers the most leverage as you can usually get bank loans to fund your rental properties and businesses with up to a 5-1 leverage.
Read Next: HOW are you taxed? Part 2
*Full disclosure I am NOT a CPA nor a certified financial advisor (or any other alphabet soup designation) and all of the information in this section is provided solely for educational purposes and does NOT constitute legal or tax advice. EVERYONE should consult their own financial advisors, CPAs and tax strategists to compile their own individualized plans.*