Bigwig CEOs don’t pay taxes, why should you?

How the pros get away with not paying taxes, and how you can too.

It’s time to party like a Rockstar. Only “partying” is paying taxes and the “Rockstars” are corporate CEOs. The irony of such a line is that Rockstars actually pay exorbitantly high taxes while the quiet billionaires signing their checks seem like they skip the Taxman all together. How can this be? Better yet: How can I skip the Taxman like they do?

First off, I’d like to point something out. CEOs do in fact, know how to skip out on taxes. Remember when Warren Buffet, the 3rd richest man in world gave that passionate speech about this very topic? The Sunday Times reported that he called out lawmakers at a fundraiser saying that he paid only 17.7% in taxes while his secretary paid 30%. Buffet was making a political statement about tax reform but why should we wait until reform when we could start not paying taxes today?

How they do it:
The key to rich people’s tax success is defining their income. For example, if you or I make a buck its called a salary or wage and its taxed in the appropriate “marginal” tax bracket. When they make a buck, its usually not in wages but a return on some investment they had. Their accountants call it “capital gains” and they only pay 15% on it regardless of how much they make otherwise. Now that might actually be fair considering they had to risk that money and our wages aren’t much of a risk and with risk, comes reward. To see a neat graph on this, check out this blog. It shows the how taxes of the 400 richest Americans are tied not to income tax but capital gains tax.


How we can do it:
Don’t worry, I’m not going to suggest that you forego all you income and invest it all in risky investment simply to lower your tax bill. But there is a principal that we can start applying today that will reduce our taxes guaranteed. Here’s the trick: instead of looking at which tax bracket you fall into on a year-to-year basis, try stepping back and consider the total amount you pay in taxes compared to total net-worth.

Rockstars pay such high taxes because they spend every dime they get. Need proof? Google: “Wesley Snipes IRS”. The pros know that the IRS builds tax breaks into the system for people who don’t spend their money. These are called IRA’s (see IRA section below). Remember that a Roth IRA is taxed now and never again, even if you get a million dollars in there. That means you’ll still be paying 20-30% of your wages in taxes, but you Roth IRA gains will be taxed at 0%. The higher the value of your Roth IRA account, the lower your effective (real) tax rate becomes.

Let’s play it out with the Smith family. They earn $70,000/year. Their first $17,000 is taxed at 10%. Everything from there up to 69,000 is taxed at 15% and that last bit is taxed at 25% (note: these do not includes state taxes). Their total effective (real) tax rate is about 14%. Not bad, but we can do better.

If the Smith’s socked away 10% of their income every year into a Roth IRA, after 10 years they would have $120,000 set aside that would never be taxed (assuming 10% growth/yr). Great news for the Smith’s but the better news would be that that all by itself that nest egg would make another $12,000/year. So the Smith’s would still be paying an effective (real) tax rate of 14% on their wages of $70,000 but the extra $12,000 isn’t taxed! That brings their actual tax rate down to about 11.9%. We just legally lowered their tax bill! It’s good to have control over taxes. Let’s keep going. What if they keep investing and really save up their nest egg? We’ll check in on them 30 years down the road. Saving 10% of their income they now have about $1.5M in tax free savings. If they still earn $70,000 that year, their savings will also earn them another $150,000 for a yearly total earnings of $220,000. Best of all, they’ll only pay taxes on their wages of $70k. They’ve just lowered their effective (real) tax rate to a measly 4.45%.

Congratulations, Smiths. You’re now partying (paying taxes) like a Rockstar (CEO).

Up Next

Up Next:

Buying life insurance, How much house to buy, and clearing up the “House as investment” misconception.

Social Security

Question: I’ve heard that I can’t count on Social Security. Is this true?

Some people say that you shouldn’t count on any Soc. Sec. payments. These people are wrong. The program isn’t going anywhere. Even when our country is $1.6 Trillion short this year, politicians are still afraid to even talk about changing it. Old people collect Soc. Sec. Old people always vote. Ergo, Soc. Sec. is here to stay. That said, it would be a mistake not plan for a reduced payment of Social Security. The most likely course of action is that the program will be whittled down every decade until people stop caring. My opinion is that even if you’re in your 20s or early 30s, you’ll still be able to count on Soc. Sec. to replace 10% of your current income. 

Your (Actual) Number

Question: How much do I need to save each month in order to retire? I don’t have a pension.

Let’s be honest for a second, if you’re in your 20s or 30s, you have no idea how what your retirement needs will be 30+ years down the line but you know you should start saving now. Let’s keep it simple and use a Rule of Thumb or two.

In retirement you won’t have a childcare expenses, life insurance payments, or a mortgage payment (hopefully!), but you WILL have extraordinarily high medical expenses that just seem to keep rising. So let’s estimate that you’ll want 70% of your current income. Social Sec. will make up the rest. Now go ahead and figure out what that is...multiply that number by 20. That’s how much you have to save. That’s your number! Easy, right? By the way, that little trick was called the “Rule of 20.” It works by assuming you live off the 5% on your nest egg. (Get it? Rule of 20 x 5% =100)

One major caveat to all this. Inflation. CNN Money estimates that if inflation rates continue, $1 35 years from will be worth $0.40 today. To get your actual number, divide your number by .4.

To keep it simple, let’s do a case study: Say the Smith’s household income is $60,000/yr. Their savings target should be: 60,000 x .70 = 42,000. 42,000 x 20 = 840,000. To accommodate inflation: 840,000 x .4 = $2.1 million. Now, that’s your number!

Starting my nest egg

Question: I just landed my first “real job.” I’m told I need to save for retirement (no pension at my employer). Where do I go to start saving for retirement?

Yes! Congratulations on the job and great foresight in looking toward retirement. If you’re in your 20s or early 30s, you’re in what I call the “money years.” These are the years most Americans aren’t saving much for retirement but will pay out huge in compounding interest when you’re in the mid 60s. So this is a great time to start. 

You should prioritize your savings in this order (assuming there’s no pension):

1. Matching 401(k). Since it’s matching, it’s literally free money. You’d be silly not to do it. But don’t contribute more than what your employer matches.
2. Roth IRA. Some people say go for the Traditional IRA first. These people are wrong. The difference is when the money gets taxed. A Roth gets taxed now and never again. A Traditional is tax-free now but gets taxed later. Obviously, there will be a lot more money to be taxed later (therefore higher taxes). But also, consider this: would you bet that taxes will be lower in the future or higher? Nearly every financial pro bets higher (Google: US Debt Crisis). So of course, you want to pay the measly 20% of $5000 now and rake in the pure untaxed millions later! By the way, there’s a $5000 limit per person on Roth IRA’s. If you’re married, you can each have one though.
3. Traditional IRA. It works the same as a 401(k) except its not tied to you employer. You can take it with you when you go. Not a bad option after you’re maxed out (1), (2) is preferred though.
4. Seriously?! If you’ve maxed out 1-3, then you make way too much money to be reading a personal finance blog. Go hire an expensive professional. 

How to do it:

Easy, simply jump on Scottrade, Fidelity, Vanguard’s website and sign up or call your cousin who sells this stuff and don’t miss another minute in your “money years”! Don’t settle for anything less than a growth stock mutual fund that’s averaged at least a 10% return in the last 5-10 years.