Life’s Largest Expense

A survey of millionaires conducted by Thomas J. Stanley and William D. Danko for their book “The Millionaire Next Door” found that taxes are their single highest expense item.  Because of this, managing taxes is one of the highest impact items that can increase your net personal income.  It is also worth mentioning that taxes work differently for employees and business owners.

Taxes for Employees

As an employee, you must pay taxes on my wages before you can spend them for the necessities and luxuries of life.  There are limited deductions and credits available to employees, and these tend to be a political football that is pushed back & forth depending on who happens to be in power during the current session of Congress.  This is the category that the overwhelming majority of people fit into.

Another thing to consider is that the US Tax code is based on progressive bracketing.  What this means is that the taxes you pay on each additional dollar of earned income goes up as your income increases into higher brackets.  Thus, as you work harder to earn more money you get to keep less of it because of taxes.  In addition to this, there is a separate schedule for taxes on gains from the sale of capital assets such as stocks or real estate.  This rate schedule generally tends to be equal or lower than ordinary income taxes for earned income, and you don’t need to pay the taxes until you sell the asset.  (Meaning that you get to control when the taxes gets paid to the man)

Taxes for Business Owners

As a business owner, the legitimate expenses of running your business are deducted from the revenue realized by your business before any taxes are paid.  If your business produces a loss, you can use that loss to reduce taxes on any wage income.  (Subject to certain limitations)  Business expenses are a much more expansive category than deductions and credits, thus giving business owners much more influence over their tax situation.  In addition to this, business owners are able to deduct numerous activities from their income, so long as those activities are pursued the purpose of conducting business.

What all of this means is that the most advantageous tax situations are (legally) attained by minimizing the income you pay taxes on by taking advantage of deductions & credits and maximizing business deductions (if applicable).  The impact of this is compounded if the result of this earned income minimization places you into a lower tax bracket.  Furthermore, it is also important to shift as much of your earning activity as reasonably possible from earned income to investment income.  This carries the benefit of a lower tax rate, and gives you control over when the taxes are paid.

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