Readers, the dustup over Mitt Romney's recent comments about taxes once again reveals a fundamental economic truism that we all should understand if we want to do the right thing financially for our families.
Here's the truism:
The US tax code treats different forms of income differently.
An important corollary to this truism is:
The US tax code treats salary income the worst of all.
Now, this is not a political blog (duh), and it is not the purpose of this post to judge whether these truisms are good or bad. For once, let's just shut it about the politics. Instead, let's focus on the reality of the tax code, and try to understand methods we can put the tax code to work for us rather than against us.
How, then, do we make the tax code work for us? A simple three-step process:
1) Identify which forms of income are taxed at favorable rates. Examples would be dividends from stocks, earned interest, municipal bond interest, interest earned from preferred stocks, and so on. [For still more ideas, see this post from my YMOYL series.]
2) Next, maximize savings of your wage income by aggressively and intelligently managing your expenses down. Ben Franklin had it all wrong when he said "a penny saved is a penny earned." Today, in an era where the combination of federal, state, Social Security, Medicare and other miscellaneous taxes can push your combined salary/wage tax rate up towards 50%, a penny saved is worth, literally, two pennies earned.
3) Third, take that money you're aggressively saving and start putting it into the income-generating investments you've identified in Step 1. This step will create additional income that will supplement the wage income you're already earning. Repeat this step relentlessly.
Look, in the eyes of the taxman, ordinary wage income is the proverbial red-headed stepchild of our family of income sources. Nobody likes it and nobody treats it well. In contrast, interest earned from municipal bonds is more like the favorite son: in nearly all cases muni bond interest is totally tax free. Also, remember: municipal bonds finance our communities' schools, libraries, roads, bridges, water treatment systems and more, so they are an important--even critical--element of the investment firmament.
To continue with my already-stretched analogy: Dividends from stocks are kind of like the Prince Harry of income sources: most dividends are taxed at just 15% (this may change come January, but even so, dividend income will still be treated more favorably than wage income).
Finally, earned interest is sort of the youngest child of the family--mostly ignored, but happy to do her own thing without all the extra attention. Earned interest (e.g., interest earned from bonds, bank deposits or preferred stocks) is taxed at your ordinary income tax rate, but it is still completely free from Social Security and Medicare taxes.
Here's your conclusion. All of these non-wage income sources are taxed at much lower rates than the wage income we've all been conditioned to work for. Understand this, and you've reached the first step towards escaping the cognitive shackles of wage-slave living. Start making these investments--and build your income from these sources alongside your existing wage income--and you actually will escape wage slavery.
One last thing. Don't slip into the lazy trap of claiming that only "the rich" can do these things. If you're gazing at some internet device and reading this post, you are in an economic position to get started on this process. So get started.
Edit: Be sure to read the follow up post to this one: Is Looking For Tax-Efficient Investments Icky? Or Intelligent?
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Posted by Daniel at 3:11 AM on Sunday, September 30, 2012