If you want to be wealthy, learn the tax code.

by w3woody

WSJ: What You Can Learn From Mitt Romney’s Tax Return

The one thing that the rich know beyond “how to start a business” and “how to hire people” and “how to sell”–all vital skills–is “what is the nature of money in our tax system.”

By that, I mean that in our tax system there are, in essence, two types of money:

  1. Pre-tax money: money that you have not paid taxes on,
  2. Post-tax money: money that you have paid taxes on.

Two things to keep in mind about pre-tax verses post-tax money.

First, if you have your own business (or are self-employed), there are plenty of things you can actually do with pre-tax money. For example, if you have a home computer software development business (which I had for 9 years), you can deduct business expenses, which include (depending on your circumstances) your home computer, memberships and subscriptions related to developing software, hardware used in testing, a portion of your home network and telephone or cell phone as used by your business. Other businesses can deduct cars, construction equipment, business trips, professional memberships, even airplanes–from your taxes.

This is the equivalent of using pre-tax money (money you don’t pay taxes on) to make these purchases.

Now much of your living expenses cannot be deducted, but instead must be paid for out of your own pocket.

This is the equivalent of using post-tax money (money you do pay taxes on) to make these purchases.

And (this is key): Taxes is the surcharge you pay to convert pre-tax money to post-tax money.

Now the amount of the surcharge you pay to convert pre-tax money to post-tax money varies depending on the nature of the way that money is made. If the money was made, for example, through capital gains, you only pay 15% on the money. However, if you take a salary, you can (depending on how much you’re making) wind up paying a lot more than 15% on top marginal income–which is essentially your cost of converting the last pre-tax dollar to a post-tax dollar.

Further, there are a number of ways to reclassify your money in order to lower the cost of converting pre-tax money to post-tax money for personal use. For example, if you can afford to delay taking your salary by a year, you may be better off restructuring your business and your income to earn the majority via stock options or by using other accounting tricks to turn it into a qualified dividend.

One reason why I was so damned pissed off with a number of people I know on Facebook and eventually left was because of the number of just absolutely stunningly stupid comments that were being made there about taxes. We have a progressive tax system, which means your marginal tax rate (or rather, the rate you pay taxes on the last dollar you make) is not the same as your overall tax rate (or rather, the percentage difference between gross income and net taxes), since everyone has deductions, and everyone pays the first $70,700 (filing joint, taxable income) at 15% or less. (If filing joint, the first $142,700 is paid at 25% or less.) And that doesn’t count the $11,900 standard deduction for married filing joint.

Because of this, even if you are making $100,000 a year, married, no other deductions, while your marginal rate is 25%, because you get a $11,900 standard deduction, you only pay tax on $88,100 of your income, and your tax burden is $14,269–an effective overall rate of 14.3%.

And if you have a small business, the cost of converting the last $10,000 to post-tax money is 25%, which means if you can buy that computer or car for your small business and declare it legitimately as a business expense, then you get a 25% discount on that purchase.

I am not offering advice; please consult your tax attorney or accountant, or at the very least don’t blame me if the IRS drags your ass down for an in-person proctology exam known as an “audit.”