Last Monday I shared a post discussing the four cashflow quadrants titled, If You Don’t Know Where You Are, How Do You Know Where You Are Going? Knowing which quadrant you fit in is key to understanding how to reduce your tax liability and get as many tax breaks as possible. Today, we are going to discuss the different quadrants and how to reduce your liability in each. First, take a look at the image below to refresh your memory on each quadrant:
Before we start talking about reducing your tax liability in each quadrant, I want to clear up one common misconception…
One Common Misconception
I am sure everyone has heard of tax brackets. Depending on how much money you make, your money is taxed at a certain percentage. And the more money you make, the higher the tax percentage is. The common misconception is that if you cross a tax bracket, then every dollar is taxed at that tax bracket level. This is NOT true. You only pay that percentage of tax for every dollar that fits within that bracket. So if you cross the next tax bracket by $1000, you ONLY pay the higher tax percentage on the $1000. The other money is taxed based on the bracket it fits in. It is important to understand that only dollars that fit in a tax bracket range are subject to that tax percentage.
Now that we have cleared that up, let’s look to see how we can reduce your tax liability in the Employee quadrant.
Reduce Your Liability In The Employee Quadrant
Your best bet for reducing your tax liability in this quadrant is to invest pre-tax earnings into a 401K or an IRA. You DEFINITELY want to put at least the amount of money into your 401K that your employer is willing to match. 401K’s and IRA’s have a limit as to how much you can contribute yearly. The important point here is to understand that the money placed in these is pre-tax. This means that it simply defers tax to a later time…typically when you retire. The thought is that you will be making less money when you retire and won’t be in such a high tax bracket. This can save you lots of money over the long haul.
Reduce Your Liability In The Self-Employed Quadrant
Being self-employed gives you the opportunity to write off business expenses. If you use a portion of your house, your car, or have any meals for any part of your business, you can write them off. This can result in some big savings if you are smart. But you have to be honest. Never falsify any of this information, as it is not worth the risk. You don’t want to be audited. If you are audited and found to have falsified information…well…good luck!!! Otherwise, any money you spend or anything you use for your business can be written off as an expense and reduce your overall income, thus reducing your tax liability.
It is worth noting that if you are self-employed, you need to pay a 15% self-employment tax. This can definitely eat into your earnings and result in you paying more in taxes. The goal is to have enough business expenses that offsets this 15% self-employment tax and then some.
Reduce Your Liability In The Business Quadrant
In this quadrant, you can make use of legal entities like corporations. There are many tax breaks that a corporation has access to that employees and the self-employed do not. One great thing is that President Trump dropped the tax rate on corporations down to 21% from 35%. That is some great savings for your business. Business also tend to have debt which can be used to lower your tax bill. You can use any profits you make to pay down your taxes, increasing your assets, but lowering your tax liability. This is a win/win.
So, what’s the difference between the Self-Employed and the Business Quadrants? The difference is how you file and if you treat yourself as an employee. If you treat yourself as an employee, you pay yourself a reasonable salary for the work you do. And it has to be REASONABLE, otherwise, it is illegal. And, well…again….good luck. Why is paying yourself as an employee help so much? Because this limits the amount of money you receive as an employee and the amount of tax you pay on that money. But what about the money left in the business? You can pay that money out as dividends & distributions, which are taxed at a much lower rate than a salary. Dividends and distribution taxes are 15% if you make less than $434, 500 a year, otherwise they are 20%. For most, that 15% tax is significantly less than the bracket they would be in if they sent the money straight through to their taxes like the self-employed do. Additionally, dividend income is NOT subject to self-employment tax. More savings!!!
Reduce Your Liability In The Investor Quadrant
The biggest benefit for this quadrant is when you hold an investment for more than a year before you cash out. When you do this, the profits are subject to Capital Gains tax, which maxes out at 20% if you make less than $425,801 a year. Since most people will fit there, you can save a significant amount of money. Stocks and Bonds are common investments in this quadrant. Another common investment here is in real estate, which has another great tax break. If you sell real estate, you can reinvest the money in more real estate and pay NO taxes at all. That’s right. The profits from from selling real estate can be re-invested, in its entirety, into more real estate making your dollar go farther and reducing your tax liability. This is how the wealthy pay no taxes at all on their real estate, while increasing their assets.
I am sure you were able to see that the biggest tax breaks are in the Business and Investor Quadrants, which is where most of the rich people reside. People in the Employee and Self-Employed Quadrants have some ways to reduce their taxes, but none as advantageous as the other quadrants. Many business owners use the corporate tax breaks to fund their investing for more tax breaks. Thus, the rich get richer, while the people in the Employee and Self-Employed Quadrants pay the most in taxes. The key takeaway here is that you want to try to move to either the Business or Investor Quadrants as soon as you can. Sure, you can make good money on the left side of the quadrants, but the right side is where the wealthy reside and are able to reduce their tax liability. So, get your butt in gear and figure out what you can do to move to the right side of the quadrants.
*** Please talk with your accountant or tax professional before you make any decisions. This post is for entertainment and educational purposes only and is not meant as financial or tax advice.