Earned income is taxed at high rates while passive income is taxed at lower rates. You have to defer your earned income and strategically use passive losses in order to beat the taxman. There are a few things everyone can learn how to do to keep more of their hard earned money.
#1 – Defer Earned Income If You’re A High Earner
Earned income is subject to the most taxes and also is the type of income that 83% of people rely on. Let’s talk payroll taxes. Social Security payroll tax of 6.2% has risen to be applied on earned income of all wages up to $127,200. Medicare is 1.45% and there is no cap but increases to 2.35% for every dollar made over $200,000. A worker who makes $127,200 a year will pay $9,731 for America’s largest two programs.
Self-employed workers will have to pay double that: $19,462 or 15.3%. It’s incredible that any self-employed person can get by with such an onerous tax.
Both self-employed workers and employees will pay the same Federal and state taxes. A worker making $127,200, with a Federal tax rate of 28% and a state tax rate of 8%, will pay an additional $45,792 in taxes with no deductions.
Reducing the amount of your earned income “on paper” is easiest way pay less in tax. Employees can contribute $24,000 to a 401(k) and an additional $6,500 to a traditional IRA in 2017 ($18,000 and $5,500 for those under 50). There are some limitations on traditional IRA deductibility if you have a retirement plan at work and make above a certain Modified AGI level.
Contributing the max $30,500 into deferred accounts saves you $10,980 annually on Federal and state taxes. Unfortunately, there is little that you can do to reduce your Social Security and Medicare payroll taxes, aside from making less money.
You can still save money on last year’s taxes as long as you contribute to a traditional IRA before the tax deadline which falls on or around April 15th. I use TurboTax as one big tax calculator to input different IRA contribution amounts to see which scenario minimizes my tax liability.
#2 – Tax Loss Harvesting
The rich have been using tax loss harvesting for years. You can use this strategy too. Selling an asset that has gone down in value and realizing a capital loss is called tax loss harvesting.
I’ve used this strategy to claim a capital loss of $12,000 ($3,000 each year for 4 years). The best time to use this strategy is to offset short-term capital gains (up to $3,000 annually) because they’re taxed at the margin. But you can also use it to reduce taxable income or to offset long-term capital gains.
There are 2 main ways to achieve the desired result:
1) Option strategy to continue to hold the asset
Scenario: You’re holding a stock or other asset that has declined in value substantially and you own increments of 100 shares. The first thing you’ll want to do is to buy an additional number of shares equal to what you already own. Then buy a put option at-the-money or at the strike price just below-the-money AND sell a covered call option at-the-money or at the strike price just below-the-money. Using the two leg option strategy allows you to effectively lock in the loss without selling the asset.
- I own 1,000 shares of Twitter (TWTR) at a cost basis of $20 per share.
- The stock declines to $15 per share, a $5,000 paper loss.
- Now the strategy – Buy an additional 1,000 shares at $15 per share.
- Buy 10 put options at least 30 days out at $15 strike for $1 per contract (total cost is $1,000)
- Sell 10 call options at least 30 days out at $15 strike for $1.50 per contract (total revenue is $1,500).
Now let’s say the stock went to $20 per share a month later. Your original shares will be called out at $15,000 giving you a loss of $5,000. You’ll have a loss of $1,000 on the put option and a gain of $1,500 on the call option. This results in a net loss of $4,500 that you can “harvest” or claim in the current year.
But here’s the great thing: you still own the 1,000 shares at a cost basis of $15 and the share are now worth $20 per share, give you a $5,000 paper gain. You were able to take advantage of the temporary decline in the stock to harvest the loss but you still hold the asset with the gain. It’s magic! You just beat the taxman. Make sure the the options you buy and sell are at least 30 days out so you don’t get wrapped up in the wash sale rules.
2) Sell the asset and buy a similar asset at the depressed price
Scenario: You own an ETF or stock that has declined in value but want to lock in the loss but continue to hold the asset. The first thing you want to do is check to see if there is another asset that is similar to the one you own but not more than 70% overlap in securities. Check out this tool to see if your ETF is too close to another asset to execute the tax loss harvesting strategy. While the IRS doesn’t define substantially identical as 70%, most tax professional agree that this is a safe percentage to use.
- Sell your S&P 500 ETF SPY for a loss of $10,000.
- Immediately buy an ETF that is less than 70% similar to the ETF you sold (purchased Schwab US Large-Cap Value ETF – SCHV)
You’ve locked in your $10,000 loss on SPY but still have exposure to the equity market through Schwab’s Large-Cap Value ETF
- Sell your ExxonMobil (XOM) shares for a loss of $10,000.
- Immediately buy the iShares U.S. Energy ETF (IYE) which includes about 25% of its assets in ExxonMobil.
- There’s no need to run any 70% substantially equivalent test as these are assets across 2 different dimensions.
#3 – Get Passive
The best way to avoid paying high taxes, specifically payroll taxes, is to generate income that is not subject to payroll taxes.
Here’s a list of passive income where there is no payroll tax due:
- Rental income
- Real estate crowdsourcing income
- Dividend income
- Bond income
- Interest income
- Venture debt income
- Capital gains (including in income)
- Business equity (including in income)
Pick one of these and commit to generating more tax-favored income to beat the taxman. I’ve been focused on dividend income and capital gains over the last few years but am branching out to other areas.
It’s much better to make $20,000 in dividend income than $20,000 in earned W2 income. Here’s how the tax numbers play out.
$20,000 taxed at 0% if you’re in the 10 or 15% tax brackets = $0 tax due
$20,000 taxed at 15% if you’re in the 25 – 39.6% tax brackets = $3,000 tax due
$20,000 taxed at 20% if you exceed the 39.6% tax bracket = $4,000 tax due
Employee Earned income:
$20,000 taxed at 6.2% for Social Security, 1.45% for Medicare, 28% Federal tax bracket, and 8% state tax bracket = $8,730 tax due
Self-Employed Earned Income:
$20,000 taxed at 12.4% for Social Security, 2.9% for Medicare, 28% Federal tax bracket, and 8% state tax bracket = $10,260
Working In Retirement
Thinking about working while in retirement? It may make much more sense to focus on generating passive income and not paying any tax on it. After all, most retirees are in a lower tax bracket than their high-earning peers. It’s very possible to keep your income in the 15% bracket in retirement while earning passive income that’s taxed at 0%!
You’ll need to keep more of your hard earned money in order to pay for the ever-increasing cost of living.
Some highlights of things you’ll pay more for in 2017:
- The Fed increased in the cost borrowing money by 0.5% since 2016
- The amount of earned income applicable to Social Security payroll tax increased by 7.3% to $127,200
- The continuation of the Medicare surcharge tax of 0.9% on earned income over $200,000 (for single)
- Health care costs continue to rise much faster than general inflation