The 3 Ways to Save on Taxes
The 3 Strategies
All tax planning comes down to three strategies. There are a myriad of ways to implement these strategies and the methods vary based on how income is earned, where in the world you are based, where the income is earned etc. but ultimately you’re looking for ways of doing these three.
#1 Reduce taxable income
This is where you decrease the amount of money the government or governments will consider taxable. The two most common ways of decreasing taxable income are making charitable donations and incurring expenses against the income, which generally involves starting a business because a business can typically write off far more than an individual.
#2 Lower tax rates
This is generally achieved either by relocating income to somewhere where the tax rates are lower or by changing the income type. For example, dividends might be subject to a lower tax rate than wages or interest, capital gains also might be taxable at a lower rate and so on. Through proper planning it is often possible to decrease the net rate payable on income.
#3 Deferral
This is when you avoid having to pay tax until later. It is common in registered retirement funds in various parts of the world. Normally, you’d be taxed on gains each year but in a deferral vehicle you don’t have to pay taxes until the end when you take it out. Capital gains through ownership of real estate and stocks tend to function this way as well they can grow without tax until the end when they are sold and then you pay a final tax but because they grew tax free they were able to compound more than if they were taxed along the way. In sophisticated cases this is often achieved by using international companies to defer income that would otherwise be taxable indefinitely.
These Strategies Compound
There’s another potential category, though it’s arguably just a reduced tax rate, which is in the case of vehicles such as insurance where growth isn’t just deferred it’s not taxable at all. Again, rules vary from one part of the world to another.
Tax shouldn’t be your leading decision point in investing, spending, or making money but it does represent one of the largest expenses for most people in their lifetime and learning to minimize those taxes can give you a significant advantage compared with others.
Take a look at just how big a difference this can make over a 20 year period using each of the three methods.
Reduce Taxable Income
Say you can reduce your taxable income by 30% by applying various deductions that come from making purchases through a business rather than personally, which allows you to spend pre-tax dollars rather than after tax dollars, watch how the numbers grow based on a 30% tax rate assuming a $100k/yr. annual income in both cases:
30% tax on full amount | Tax on reduced amount | |
---|---|---|
Year 1 | $100k @ 30% = $70k | $70k @30% + $30k = $79k |
Year 2 | $100k @ 30% = $70k + $70k = $140k | $70k @30% + $30k = $79k + $79k = $158k |
Year 3 | $100k @ 30% = $70k + $140k = $210k | $70k @30% + $30k = $79k + $158k = $237k |
Year 4 | $100k @ 30% = $70k + $210k = $280k | $70k @30% + $30k = $79k + $79k = $316k |
Year 5 | $100k @ 30% = $70k + $280k = $350k | $70k @30% + $30k = $79k + $79k = $395k |
Year 6 | $100k @ 30% = $70k + $350k = $420k | $70k @30% + $30k = $79k + $79k = $474k |
Year 7 | $100k @ 30% = $70k + $420k = $490k | $70k @30% + $30k = $79k + $79k = $553k |
Year 8 | $100k @ 30% = $70k + $490k = $560k | $70k @30% + $30k = $79k + $79k = $632k |
Year 9 | $100k @ 30% = $70k + $560k = $630k | $70k @30% + $30k = $79k + $79k = $711k |
Year 10 | $100k @ 30% = $70k + $630k = $700k | $70k @30% + $30k = $79k + $79k = $790k |
Difference | -$90,000 | +$90,000 |
A $90k difference in 10 years might not seem like much on the surface but this doesn’t count the compounding value of those figures. What if the difference was invested at a rate of 10%/yr. Now, the difference would be over $166,000! This is without assuming you could then apply deductions to the superior investment returns and earn an even greater difference!
This is a 24% difference in the total available capital after only 10 years. What if you could have earned higher deductions? What if you were compounding over 20 or 30 or 40 years instead of only 10? What if you could invest the capital at higher rates? What if the tax rates were higher than 30%, which they are in much of the world. This 24% advantage could easily be a 50% advantage or better.
Look at it another way. If you had an extra $166,000 after 10 years how many family vacations would that pay for? $16,600 per year for 10 years will pay for one hell of a vacation or maybe even three or four great vacations per year.
Let’s keep going.
Lowering the Tax Rate
Say you could reduce your tax rate from 30% to 15%, what kind of effect would this have over 10 years based on a $100k annual income?
30% tax | 15% Tax | |
---|---|---|
Year 1 | $100k @ 30% = $70k | $100k @ 15% = $85k |
Year 2 | $100k @ 30% = $70k + $70k = $140k | $100k @ 15% = $85k + $85k = $170k |
Year 3 | $100k @ 30% = $70k + $140k = $210k | $100k @ 15% = $85k + $170k = $255k |
Year 4 | $100k @ 30% = $70k + $210k = $280k | $100k @ 15% = $85k + $255k = $340k |
Year 5 | $100k @ 30% = $70k + $280k = $350k | $100k @ 15% = $85k + $340k = $425k |
Year 6 | $100k @ 30% = $70k + $350k = $420k | $100k @ 15% = $85k + $425k = $510k |
Year 7 | $100k @ 30% = $70k + $420k = $490k | $100k @ 15% = $85k + $510k = $595k |
Year 8 | $100k @ 30% = $70k + $490k = $560k | $100k @ 15% = $85k + $595k = $680k |
Year 9 | $100k @ 30% = $70k + $560k = $630k | $100k @ 15% = $85k + $765k = $765k |
Year 10 | $100k @ 30% = $70k + $630k = $700k | $100k @ 15% = $85k + $+765k = $850k |
Difference | -$150,000 | +$150,000 |
This alone creates a difference of $150,000. What if the difference each year could be invested and compounded at 10%/yr.? This would yield a difference of nearly $278,000!
Again, what if those investment returns were subject to a lower tax rate so there was a double compounding effect? What if the tax rates were $40 and 20% respectively as is loosely representative of capital gains or dividends rates in the US as of the time of this writing? What if we extrapolated this same process out over 20, 30, or 40 years? Already this is nearly a 40% advantage over the higher tax rates.
Again, what could you do with an average $27,800 per year extra? This is practically a full time salary for some people. You could buy a decent car each year for that price without having to ever worry about reselling the old one. You haven’t made any more money in this example, you’ve just kept more of what you’ve made.
But we’re not done.
Deferral
Deferral only really matters when you can compound the difference, but the difference this compounding can make is huge. To really represent the difference we’re going to look at the impact of $250k invested at a rate of 10%/yr. based on a tax rate of 40%. In the first scenario we assume the gains are taxable each year while in the second there is no tax payable until the very end.
40% Tax Annually | 40% Tax at the End | |
---|---|---|
Start | $250k * 10% = $25k * 60% | $250 * 10% = $25k + $250k |
Year 1 | $265,000.00 | $275,000.00 |
Year 2 | $280,900.00 | $302,500.00 |
Year 3 | $297,754.00 | $332,750.00 |
Year 4 | $315,619.24 | $366,025.00 |
Year 5 | $315,619.24 | $402,627.50 |
Year 6 | $354,629.78 | $442,890.25 |
Year 7 | $375,907.56 | $487,179.28 |
Year 8 | $398,462.02 | $535,897.20 |
Year 9 | $422,369.74 | $589,486.92 |
Year 10 | $447,711.92 | $648,435.62 |
After Tax | $447,711.92 | $489,061.37 |
Difference | -$41,349.45 | +$41,349.45 |
Year 20 | $801,783.87 | $1,681,874.99 |
After Tax | $801,783.87 | $1,109,124.99 |
Difference | -$307,341.12 | +$307,341.12 |
Year 30 | $1,435,872.79 | $4,362,350.57 |
After Tax | $1,435,872.79 | $2,717,410.34 |
Difference | -$1,281,537.55 | +$1,281,537.55 |
Year 40 | $2,571,429.48 | $11,314,813.89 |
After Tax | $2,571,429.48 | $6,888,888.34 |
Difference | -$4,317,458.85 | +$4,317,458.85 |
In this case after 10 years we see an advantage of around 10% or a little over $40,000 but look how it inflates after 20 years, 30 years and 40 years! After 20 years the difference is over $307,000! More than $15,000/yr. on average or more than 38% more in total. By 30 years the difference is over $1.2 MILLION DOLLARS! Or approximately $40,000/yr. representing nearly 100% more almost twice as much money in your pocket! This is nothing though, by 40 years the difference is over $4 MILLION DOLLARS! More than $100,000/yr. nearly triple the amount of money in your pocket even after all these taxes.
What Do They Look Like Together?
Now imagine you could combine these strategies together?
Rather than simply deferring at the end of the deferral period instead of paying 40% tax you’d only pay 20% tax. This would add more than $2 MILLION EXTRA to your already substantial advantage.
This is essentially what Warren Buffett has done. He buys stocks that he never sells thereby deferring his taxes for literally decades (you think this is big imagine at 50 or 60 years what the impact would be). Then when he does sell he pays favorable tax rates of approximately half what the normal person would on their regular income. In his case on top of all the rest instead of growing his capital at a rate of 10%/yr. as most people do he grows his capital at a rate of 20+%/yr. Based on those numbers the advantage is almost $300 MILLION DOLLARS! All off a $250k investment made 40 years ago.
These are not fancy tax strategies available only to the rich. Anyone can do these and they are part of the way to become rich!
Start a business so you can write off expenses and in many cases either avoid or get sales tax back.
Utilize tax deferral or tax reducing vehicles to invest. Or invest in long term assets that compound tax deferred.
In the short run the advantages are minor, that’s what’s so deceptive. Wealth is built over time and the effect of compounding is very hard to understate.
If you need assistance or have questions contact us.