HOW TO (LEGALLY) NEVER PAY TAXES AGAIN

Warren Buffett once said that his secretary probably paid a higher tax rate than he did, despite the fact that he was making millions of dollars each year and his secretary almost certainly wasn't. But how can this be true? The tax system, at least in the United States, is what's known as a progressive tax system. This means that those who earn more money and therefore have a greater ability to pay taxes see a higher portion of their earnings taxed. As of the federal tax year 2020, the federal tax brackets for married couples break down like this. For the first $19,750 of taxable income, you pay 10% for a maximum bill of $1,975. For any taxable income above the $19,750 threshold but at or below $80,250, you pay 12% for a maximum bill of $9,235. For any taxable income above $80,250 but at or below $171,050, you pay 22% for a maximum bill of $29,211. This pattern continues for the 24%, 32%, 35%, and 37% tax brackets. So as you can see, a family with a taxable income of $19,750 would pay about $1,975 in taxes for an effective tax rate of about 10%. A family with an $80,250 taxable income would pay $9,235 in taxes for an 11.5% effective tax rate. And a family pulling in $171,050 would have to cough up almost $30,000 in taxes for an effective tax rate of about 17%. As far as systems go, on its surface, it's not that bad. So how does Warren Buffett and other wealthy people manage to pay a lower effective tax rate than a secretary who may be making a mere $30,000 to $40,000 a year? And are his techniques something that we can reproduce? Amazingly, the answer is, for the most part, yes. And that's what we're going to be talking about today. Let's talk about how you can legally lower your tax bill, possibly even to zero, for the rest of your life. This is how to legally never pay taxes again. But before we get going be sure to like this video if you haven't already as it really does help out the channel a lot and subscribe with notifications on for more money-related videos like this one every single week. And if you want to further support this channel you can check out some of the links I've left in the description below, which includes a 30-day free trial of Audible and two free audiobooks of your choice as well as a list of some books on money I'd recommend checking out with your free trial. So before we get into just how to lower your tax bill, possibly all the way down to zero, you need to understand something. The rich play by different rules than we do. Not because the usual rules don't apply to them or because they are somehow held to a different standard, but more often than not just because they know what the rules actually are. Most people don't understand tax laws, or at least have a good tax pro in their corner who does, and as a result they pay a lot more than they really should have to Uncle Sam each year. For instance, did you know that there's more than one type of income? Well, for tax purposes anyway, there is, and they can be treated incredibly differently when it comes to how much you'll actually pay when the bill comes due. The three types of income, at least according to Uncle Sam, are earned income, passive income, and portfolio income. Earned income is the type of income we're all probably most familiar with as it's the first one we generally start earning. It includes things like wages from a job, income from a side hustle or business you own, bonuses, tips, and any other income that is earned as a direct result of your labor. This income is taxed at ordinary income tax rates, which we went over a minute ago. Passive income often includes things like rental income from real estate and income from limited partnerships or businesses in which you're invested but don't materially participate. These types of income are often taxed at your ordinary income tax rates as well, but there are often additional deductions that you can take to lower your taxable income, especially when it comes to things like real estate, before your actual tax bill is calculated. Some examples of this are depreciation and, depending on how your real estate business is set up, possibly a qualified business deduction, but those are details way beyond the scope of this video so if you have interest in those areas be sure to talk with your tax advisor to learn how to best manage your tax situation. Portfolio income, or sometimes referred to as investment income, includes things like capital gains from the sale of assets such as stocks and index funds, but can also include things like qualified dividends on those investments. And I say it can include dividends because, depending on a few factors, they may be taxed at your capital gains tax rate or your ordinary income tax rate. For instance, for a dividend to qualify for capital gains treatment, it must meet a few requirements. First, it must have been paid by a U.S. company or qualifying foreign company. Second, it can't be listed as a type of dividend that the IRS automatically disqualifies from You can see a full list of the types of dividends that don't qualify on the IRS's website if you're interested. It's in Publication 550, just google IRS Qualified Dividend Rules and it should come up. And third, you must have met the qualified holding period requirements. The holding period differs slightly depending on the type of investment that it is, but something like shares of common stock must be held for more than 60 days during the prior 121-day period that starts 60 days before the ex-dividend date. You should receive a 1099 form for your dividend income each year and it'll list how much of your dividends are qualified for capital gains treatment and how much aren't. The capital gains themselves can also be taxed at your ordinary income tax rates if you only hold the investment for a short period of time. In general, assets that you held onto for at least a year plus one day before selling term capital gains tax rates. If you've held your investment for one year or less, they'll be taxed at your ordinary income tax rates in most cases. So what are these favorable long-term capital gains tax rates? Well, according to NerdWallet, the brackets for the 2020 tax year for married couples are 0% for incomes between $0,000 and $80,000, 15% for incomes between $80,000 and $1,000, and $496,600, which I mean, it's not zero, but it's quite a bit lower than the 22% to 35% that you'd be paying in this range for ordinary income, and finally 20% for any income over $496,600. These brackets do include your taxable earned income, so if you and your significant other work full-time and earn $50,000 a year combined, you couldn't then turn around and sell your assets and realize $80,000 worth of your capital gains without paying any capital gains taxes. You could sell enough assets to realize $30,000 in capital gains without paying any capital gains taxes, since your total taxable income would then add up to $80,000, but again, for any specifics, consult with your tax professional. But anyway, this strategy is known as capital gains harvesting, and it can be important particularly for those with long time horizons or those who are in retirement. For example, picture a retired couple with a $500,000 nest egg invested in a taxable account. If it earns 8% per year, then it will appreciate by about $40,000 and rise to $540,000 during that first year. This leaves the couple with a $40,000 unrealized gain on paper. Let's also say that it pays a 2% qualified dividend each year. This gives our couple an income of $10,000 in that first year, which is taxed at the capital gains rates. Obviously, since it was only $10,000, in this case, the rate would be 0%. We'll say the rest of their income comes from a Roth IRA, which is obviously not taxed when you're withdrawing it. Over the next 10 years, assuming they just allowed that taxable nest egg to continue to grow at 8% per year, it would be worth just under $1,000,000, with $500,000 of that being the amount they invested, or their cost basis, and the other $500,000 being an unrealized capital gain. The dividend would now be paying our couple about $20,000 per year. Hypothetically, they could sell off all of their investments and realize the entire $500,000 worth of gains in one year, but that wouldn't be the most tax-efficient move. It would end up costing them nearly $73,000 in capital gains taxes because of the brackets we went over a minute ago. Instead, what they could do is let their investments and dividend income rise in year 2 to $540,000 and $10,800 for the year respectively. Then they could sell off enough of their shares to realize $69,200 worth of gains in that second year as soon as they had held the investments for long enough to qualify for that long-term capital gains treatment, which again is 1 year plus 1 day. This combined with their dividend income will bring them all the way up to the top of that $80,000, 0% long-term capital gains tax bracket. And therefore, they won't owe a penny in capital gains taxes. They then would immediately rebuy their investments for the current market price and essentially wipe out their $40,000 of unrealized gains in the process and avoid that potential big tax bill down the road. Since they are selling and buying the investment at more or less the same price, the amount of shares they own, and therefore the dividend income they receive, will not be affected very much by this strategy, nor will their overall net worth. The only real thing that's changing is how Uncle Sam is going to calculate their capital gains taxes when they do eventually sell their taxable investments for good. Our couple could repeat this process by selling off enough shares to get them to the top of that 0% long-term capital gains tax bracket and then immediately rebuy the investments to raise their cost basis year after year and avoid triggering a future tax bill for the rest of their lives in retirement. But for now, let's move on to some exceptions to these brackets that you should be aware of. First, collectibles, such as coins or precious metals, are taxed a little differently as they have a maximum tax rate of 28% instead of 20% even if you've held it for more than a year and a day. And those who have incredibly large amounts of investment income may be hit with an additional 3.8% net investment income tax. Thresholds are $200,000 for singles and head of households, $250,000 for married couples filing jointly, and $125,000 for a married couple filing separately, according to Nerd Wallet. Finally, some states do treat capital gains differently than the federal government does. So depending on where you live, you may still incur some sort of a tax bill during your working career. Though once you're financially independent, you can choose to live somewhere with a more favorable capital gains tax treatment if you so wish. But in general, these are the rates. Even with those exceptions, I'm sure you can see how powerful of a tool capital gains income can be for earning an income while paying very little, if any, taxes. Ultimately finding a way to minimize the portion of your income that comes from sources that are considered earned and raising the portion that comes from your portfolio is how Warren Buffett and the rich in general manage to pay out smaller portions of their income in But in order to start earning investment income, you first need to earn money and invest. So how do you manage your tax bill during your working career when most, if not all, of your income comes in the form of that earned income that Uncle Sam's refers to? Well, you take advantage of the tax-advantaged accounts that the government has provided for us. There are two things you need to do to lower your tax bill when you're working and earning that earned income. You need to ensure that you have a very low burn rate and you need to invest any surplus cash you can toward funding your tax-advantaged accounts. The reason you need a low burn rate is because the government actually allows you to earn some money without paying taxes on it each year. Remember that the tax brackets we went through at the beginning of the video were calculating your tax bill based on your taxable income, which is not the same as the amount of money you make in a year. Your taxable income is the amount of money you make in a year minus the standard deduction or your itemized deductions if you choose to itemize, but a lot of people don't choose to do that ever since the Tax Cuts and Jobs Act because it raised the standard deduction. You also have to then take away any other deductions you may qualify for, such as the investment deductions that we'll go over in a minute. The standard deduction is set at $12,400 per year for singles and $24,800 per year for married couples. Hypothetically, then, if a married couple were able to be frugal enough to live on no more than $24,800 per year, they would be able to pay no federal income taxes on the money they earn. This, on its own, is pretty cool, but it can get really cool when you earn a good amount of money and take advantage of your tax-advantaged accounts with the leftover cash. The three main accounts people use to lower their tax bill while working are the 401k, IRA, and HSA. As of 2020, an individual can contribute $19,500 per year out of their salary to their 401k. If you're over the age of 50, you can actually contribute an additional $6,500 for a total of $26,000 per year into your 401k. And if they put this money into their traditional 401k, it will not be taxed by the government when you put the money in. You can contribute up to $6,000 per year to an IRA if you're under the age of 50. For those over the age of 50, you can contribute an additional $1,000 per year for a total of $7,000 into your IRA. For the HSA, individuals can contribute about $3,550 in 2020 if they're under the age of 55. Families can contribute up to $7,100. The catch-up contributions for those age 55 and older is $1,000. Total that all up and a couple could theoretically invest $58,100 per year if they're under the age of 50 and all of that money would be earned and invested without paying any taxes up front. In other words, the family could earn $82,900 per year, live on $24,800, and invest the rest without paying any federal income taxes up front. That's pretty incredible. But the other question that I'm sure many of you have thought of is if all their savings are going into traditional retirement accounts, won't they have to pay taxes on the money when they withdraw it? The answer is, it depends. It depends on how you set up the rest of your financial picture during and after your working career is over. Money in your HSA can be withdrawn tax-free for qualifying medical expenses, as we've discussed in a previous video. So long as you're using money in that account to cover medical things in retirement, there should be no issues. For the 401k and IRA, though, we need another strategy. We need the Roth IRA Conversion Ladder. For those who don't know, the Roth IRA Conversion Ladder is a technique that allows you to convert funds in your traditional IRA over to a Roth IRA. The amount of money you can convert can be withdrawn from the Roth IRA penalty-free and tax-free after a 5-year waiting period. And because of the beauty of the standard deduction and the 0% long-term capital gains tax bracket, you can actually convert that traditional IRA money to a Roth IRA without paying any taxes if you do it right. Let's say that John and Jane had a taxable account that produced $40,000 a year in qualified dividends for them. Based on what we learned about the tax treatment on qualified dividends, we know that they'd pay $0 in federal income taxes. Let's say they also had a traditional IRA valued at $200,000. They could choose to convert some of that money over to a Roth IRA. Say they converted $24,800 for the year, which is equal to the standard deduction for married couples. The money they converted would be counted as earned income, but remember how your tax bill is calculated. It's not based on the amount you earn, it's based on whatever your taxable income is for the year. Since John and Jane only converted $24,800, their standard deduction would actually wipe that entire conversion out, leaving them with a $0 taxable income. As we all learned in math class, anything times 0 is still going to be 0, so they won't pay anything in taxes for the conversion. They would continue converting money from their traditional IRA over to their Roth IRA up to the standard deduction every single year. On January 1st of the 6th year, they would be allowed to withdraw that original $24,800 they converted in their first year, tax-free and penalty-free. On January 1st of the 7th year, they could withdraw whatever they converted in year 2 of their retirement, and so on and so forth. That's how you access your retirement money while paying little to no taxes on it, up front or down the road. So those are the basics of the tax-free or at least minimum tax lifestyle. Now let's take a moment and put it all together with an example. Let's say that John and Jane are both 30 years old and make a combined $100,000 a year. They go through their budget, take advantage of rent and transportation hacking, and manage to get their expenses down to $24,000 a year. They both max out their 401ks, IRAs, and an HSA, and this leaves them with a taxable income of $17,100 each year. Looking at the federal tax brackets we laid out earlier, this suggests a total federal income tax bill of about $1,710, or about 1.71% of their income. Compare that to someone who didn't take advantage of the tax-advantaged accounts. They would have a federal income tax bill of over $13,700. Even someone making $30,000 a year would technically be paying more, both in terms of raw dollar amount and as a percentage of income, assuming they didn't take advantage of their tax-advantaged accounts. In this case, it would be a tax bill of around $3,200, or nearly 11% of their income. Now again, every state's income tax brackets look different, so depending on where they lived they may have a little more taxes to pay than just this, but I'm going to assume for the case of this video that they live in one of the states with no state income tax, as it won't make much of a difference to the overall point we're trying to make here. After those investments, taxes, and living expenses, they still have a little less than account. John and Jane ensure that they are investing in things that get long-term capital gains treatment so that they can limit their tax burden down the road. For the sake of simplicity, we'll assume that all of their investments earn an average 8% return per year. John and Jane want to retire at age 50 with a $40,000 per year income, and given these assumptions they should be able to make that work. Under this scenario, John and Jane will retire at 50 with a total net worth just north of $3.67 million. Obviously I'm rounding a bit here, but that $3.67 million is split up as follows. $963,000 each for John and Jane's 401k, $297,000 each for their IRAs, and $350,000 in the HSA. The last $800,000 is in their taxable account. Of that $800,000, $476,000 of it was growth that they'll be able to harvest. John and Jane both retire at age 50, and so their earned income drops to zero. To make things simpler, they consolidate their traditional 401ks and IRAs into one traditional IRA account, which will be valued at $2.52 million. They convert $24,800 of that to a Roth IRA to begin their conversion ladder. They then take their $40,000 of income out of their taxable account to live on for the year. This drops its value down to $760,000, though hopefully they'll gain some of it or even all of it back with the growth of their investments throughout the year. At 8% per year, $760,000 grows by about $60,800, so that is possible even if it isn't guaranteed. Their total taxable income is $40,000, so they'll be able to sell off about an additional $40,000 worth of capital gains from their taxable account and immediately buy the investments right back at the current price, raising their cost basis and avoiding a potentially huge tax bill down the road, as we discussed before. But the real point is that their total tax bill for the current year is $0.00, because the $40,000 in income is being treated as long-term capital gains. They repeat this process in year two. Assuming their returns stayed the same, their net worth would begin the year at about $3.925 million. The key accounts would be the Roth IRA and the taxable account, since the Roth IRA can be withdrawn from tax and penalty-free starting at the age of 59 and a half, and the taxable account produces their tax-free long-term capital gains income. The Roth IRA sits at just under $26,800, but thanks to the second year's conversion and the investment appreciation, it will rise to about $55,700 by the end of year two. The taxable account actually sits at around $824,000 to start the year. Assuming growth stays the same, it will reach about $850,000 by the end of the following year. As you can imagine, John and Jane will continue this process, converting money from their traditional IRA to their Roth IRA for many years to come. They will continue withdrawing from their taxable account to fund their lifestyle. The only real decision that needs to be made at this point is how they want to handle their required minimum distributions when they turn 72. Thankfully, though, they do still have enough time to plan ahead for that. But that'll do it for me today. Once again, if you enjoyed this video be sure to smash that like button. 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