Rich people have the luxury of using fancy and expensive accountants, tax advisors and tax lawyers to pay as little in taxes as possible. Generally, this is all done within the legality of the tax code and explains the reason why someone like Warren Buffett, with a net worth of $53.5 billion, pays less in taxes than his secretary.
These same rich people have cool things like tax havens at their disposal – countries like the Cayman Islands where taxes are collected at a lower rate or even not at all – to completely avoid taxes. Everyday people like us don’t have the problem of trying to avoid paying taxes on millions or billions of dollars.
However, there is a surprise in store for us if we are financially independent, or on the road to financial independence, and we’re relatively frugal with our everyday dollars.
After I submitted my tax return this year I got to thinking about how much tax an individual or family that is financially independent – generating all living expenses through dividends and capital gain harvesting – would be on the hook for.
First, let’s check out what the 2013 tax rates are on ordinary taxable income.
2013 tax rates for income
|Tax Rate||Single||Married||Head of Household|
|10%||up to $8,925||up to $17,850||up to $12,750|
|15%||$8,925 to $36,250||$17,850 to $72,500||$12,750 to $48,600|
|25%||$36,250 to $87,850||$72,500 to $146,400||$48,600 to $125,450|
|28%||$87,850 to $183,250||$146,400 to $223,050||$125,450 to $203,150|
|33%||$183,250 to $398,350||$223,050 to $398,350||$203,150 to $398,350|
|35%||$398,350 to $400,000||$398,350 to $450,000||$398,350 to $425,000|
The median household income for the US, according to the latest available data from the Census Bureau, is $50,502. According to the tax rates above, this household would need to pay up to 25 percent of that $50,502 to the IRS.
However, this household’s average tax rate is closer to 12 percent. Remember, the first $8,925 of income is taxed at 10 percent, the next $8,925 to $36,250 is taxed at 15 percent, and finally the last $36,250 to $50,502 is taxed at 25 percent.
Therefore the median household will owe around $6,000 in taxes, leaving them with $44,500 everyday dollars.
The question is how can we, the non-rich, legally avoid paying that $6,000? Let’s first talk about dividends and capital gains.
For readers of this blog who might not know what a dividend is, it’s a payment made to shareholders of a company that is paid from the company’s profits. Typically, it’s paid as cash and deposited directly into the shareholder’s brokerage account. Most US companies pay dividends on a quarterly basis.
From the chart we can see that Starbucks started paying a dividend in 2010, and over the last three years have increased it from 10 cents per share to 21 cents per share. As long as they keep doing better and making more money, they will keep raising the dividend.
Why would a company just give away their money to shareholders? Well, some successful companies run into a problem: they make more money than they know what to do with. If they can’t reasonably redeploy their cash into their business they choose to return some of it to the shareholders.
As we can see, over the course of 2012 Starbucks paid a total of 72 cents in dividends per share. Pretty cool, huh?
For the geeky investment readers: if you had bought Starbucks during the recession at say $10 – and it went even lower than that – the dividend yield on those shares would be a whopping 7.2 percent! An awesome return just for holding shares.
And that is the power of dividends. It isn’t the present dividends that matter, but those dividends to be paid in the future. This is how wealth is built.
The one downside to receiving dividends is when the shares are held in a taxable account; it’s considered income and the shareholder will owe taxes on that money, based on the current tax rates.
For readers unfamiliar with capital gains, it’s a term used to describe an increase in the value of an asset, like a stock or a home, that gives it a higher worth than the purchase price. Simply put, it’s the money you make on an investment.
For example, let’s say you bought a share of Google (GOOG) in 2010 at $500 and then you sold it when it reached $750 in 2012.
You wouldn’t owe any taxes for holding your share of Google in 2010 or 2011 or even if you held it for 20 years. But when you sold it in 2012 for $750 you generated a capital gains event. The $250 difference you pocketed between where you bought the share and where you sold it needs to be claimed as a capital gain, and taxes apply to it.
There’s two types of capital gains, short term and long term. Short term capital gains is when an asset is held one year or less and long term capital gains is when an asset is held more than one year. Tax rates are typically higher on short term gains and lower on long term gains.
Now that we understand what dividends and capital gains are all about, let’s check out how they are taxed.
2013 tax rates for dividends and capital gains
|Tax Rate||Single||Married||Head of Household|
|0%||up to $36,250||up to $72,850||up to $48,600|
|15%||$36,250 to $400,000||$72,850 to $450,000||$48,600 to $425,000|
Back to the question at hand. How can we legally not pay any tax? It’s simple.
We choose to design our life so that we are a top performer in our careers and thereby make the most money we can. At the same time we condition ourselves to be frugal minimalists and live well below our means, yet comfortably. This allows us to be able to save and invest plenty of money so after working 15, 20, maybe 25 years, we have an investment portfolio large enough that we can call ourselves financially independent. We retire early.
For example, let’s assume we’ve done that and built a $750,000 portfolio. Through dividends and capital gains harvesting it throws off a nice 4 percent every year. That’s $30,000 a year – $2,500 a month – in everyday dollars we use to live our lives.
And if we look at the tax chart above, we can see that we’ll owe exactly $0 in taxes on it.
Our lifestyle design becomes our tax haven.