9 Tax Secrets of the Rich They Don’t Teach You Anywhere

When people talk about tax loopholes and other shenanigans, it’s usually very small or illegal.

We don’t want to waste time doing anything small… and we want to avoid anything illegal. We definitely want to avoid anything illegal.

Taxes are a pretty easy game to understand. There are just two pieces to this vexing puzzle – income and expenses.

Income is when you take in money, whether from a day job or from investments, and you are taxed on that income based on the type of income. Some income is taxed at a higher rate than others. It’s all about what actions the government has decided to incentivize.

Expenses are when you pay out money, whether to your mortgage company or to the local grocery store, and you may be able to deduct that from your income depending on what expenses the government has decided to incentivize.

Like chess, the pieces are easy to understand but the game is still difficult. You know how the pieces move with respect to taxes, here’s how to move them in concert to reduce your tax burden.

🔃Updated April 2024 with updated tax figures for 2024.

Defer Income, Accelerate Expenses

You only pay taxes when you take in money.

This idea isn’t a secret, I lead with this idea because it is a foundational tax idea everyone should know.

When you are paid a salary, your company withholds some portion of your income in every paycheck. You may get some of it back at tax time but whatever you owe is being paid at the time you are paid. If you defer some of your income, such as into a 401(k), you aren’t taxed on that contribution on payday. That’s a tax deferred retirement vehicle so your taxes are owed whenever you start taking disbursements in retirement.

The theory behind tax-deferred retirement investing is that your tax rate in retirement will likely be lower than your tax rate now. You’re working a full-time job with a salary right now, so your marginal tax rate is theoretically higher than when you’re just pulling in payments from your retirement accounts and Social Security.

The key is to defer income as long as you can bear, financially.

For expenses, you deduct them in the year you spend the money. If you can accelerate expenses from next year to this year, you can deduct it against your income and lower your tax burden. In some cases, like a mortgage interest deduction, acceleration seems to only give you an advantage in the first year (the first year you do it, you have 13 payments – in subsequent years, you still only have 12 because your January went to the previous year). For those, the idea is that you may want to accelerate and then defer so you have years where it’s 13 payments and years where it’s 11. There may be some advantage for those 13 payment years there, your individual tax situation will dictate that.

Defer income and accelerate expenses.

All Income Is Not Taxed Equally

Many experts will tell you that we have a progressive tax system where the rich pay the most taxes.

If you look at the tax brackets, you might believe them.

When someone works a regular job with income reported on a W-2, they pay federal and state income taxes on all income. They also pay a payroll tax, which is for Medicare and Social Security and known as FICA. The Social Security portion, 6.2%, is only assessed on income up to the wage base ($168,600 for 2024). The Medicare portion, 1.45%, is assessed on all income.

If someone is self-employed with income reported on a Form 1099, they pay federal and state income on all income. They also pay a payroll tax but it’s called self-employment tax because they pay both sides – employer and employee. The tax works out to be 15.3% for all income up to the wage base and then 2.9% on income above it.

Let’s say you are not working a W2/1099 job and the only income you earn are dividends and interest.

Qualified dividends are taxed extremely favorably. If you are in the 10% or 15% tax bracket, they are taxed 0%. If you are the others, it’s taxed at 15%. No payroll tax. (if you are a high earner, you may be subject to the net investment income tax of 3.8%) If you sell a business and have the proceeds taxed as long term capital gains, it’s treated the exact same way.

If you are a small business owner, it is better for you, tax-wise, if you reinvest all income and build equity in the business that you can sell in the future. Any income you earn from the business will immediately get hammered by FICA for 15.3% and then for your tax rate. If you sell it, you are only burdened by long term capital gains.

If you have a choice, you want to earn (or pass along) your income in this order:

• Estate tax – technically not “income” but assets get step up tax basis and the transfer is not taxed up to a large amount (currently $13.61 million per person in 2024), this is after you take full advantage of the structure of gift taxes before you pass
• Capital gain on a home – tax free on the first $250,000 ($500,000 for couples), more on this below
• Long term capital gains – Taxed at long term capital gains rates
• Qualified dividend income – Taxed at long term capital gains rates
• Short term capital gains / interest income – Taxed at your marginal tax rate but not subject to FICA
• Regular income – Taxed at your marginal tax rate but subject to employee’s side of FICA
• Self-employment income – Taxed at your marginal tax rate but subject to employer and employee FICA (self-employment tax)

The rich do pay more in taxes but their tax rate may be much lower. This is why Warren Buffett famously said he pays a less in taxes than his secretary.

Defer taxes with 1031 Exchanges

If you thought long term gains were sexy, wait until you hear about 1031 Exchanges.

1031 refers to Section 1031 of the Internal Revenue Service Code. What it lets you do is avoid taxes on gains when you sell something if you immediately (within 45 days) reinvest the proceeds into a similar property as part of a “like-kind exchange.” The tax is deferred, so it’s not tax-free, much like a 401(k).

It can get pretty complex as to the mechanics but the idea is straightforward. There are a few other rules, like property can’t be for personal use (you can’t exchange your primary residence), and it can’t be inventory, securities (stocks, bonds, notes), etc. The IRS keeps a whole list if you’re interested.

RealtyMogul, a popular real estate crowdfunding platform, goes as far as identifying 1031 Eligible properties for you to invest in. As more investing platforms do this, regular folks will be able to take take advantage of 1031 Exchanges.

Savings Offer Flexibility

If you have monthly fixed costs of $1,000 and you make $1,500 each month, you have no financial flexibility. You can’t defer income easily. By accumulating savings, you give yourself the ability to play accounting games with your money so you can defer less in taxes. Up your savings rate and up your tax game.

If you were a business owner, this is especially powerful because you have a tool a regular employee doesn’t – equity. If you don’t have savings, you have to take a salary because you have bills to pay. If you have flexibility, you can reinvest your income into the business to try to build equity. You convert that equity into cash whenever you sell the business and if you held it for over a year, you pay long term capital gains. That is taxed far better than income.

By the way, if you run a business and can hire your kids, any kid under the age of 18 that works for their parents does not have to pay Social Security or Medicare taxes.

You need to save as much as you can, bank the cash and let it grow, so you can live off savings if the tax situation calls for it.

Claim Paper Losses

Loss harvesting sucks. No one likes admitting they made a mistake and no one wants to realize a loss… except tax-advantageous people.

Tax-loss harvesting is when you sell a losing investment, capturing a realized loss, and use it to offset gains you want to bank. The stock market will regularly go through massive drops and investors use these times to capture losses. The two most recent ones were the Dot-com bubble burst and the Great Recession.

When people do this, they sell a losing investment and immediately invest it in something that is similar but not identical (known as the wash sale rule). So they may sell an S&P 500 index fund and reinvest that money into a Total Market index fund. The rule is you can’t reinvest it into “substantially similar assets” but it’s not clear what that means. I wouldn’t sell an S&P 500 index fund and immediately buy an S&P 500 ETF, but what if you bought a small-cap index fund? No one really knows.

The losses carry over from year to year, so you can bank a lot of loss and just use it when you want to capture gains. You can also use $3,000 per year to offset regular income, which is an even bigger tax benefit.

Losing money sucks but it’s part of investing, so lose it the right way and maximize the tax benefits.

Move to a Lower Tax State

We often overlook state taxes because federal taxes are a more popular subject but state taxes are significant.

State and local governments need taxes to fund their budgets but each state goes about it differently. Some states have high personal income taxes. Some states have a high sales tax. Others rely on property taxes or business taxes.

In my home state of Maryland, we pay a state income tax of 2%-5.75%, a Howard County income tax of 3.2%, and property taxes of around 1.30%. That adds up!

(Maryland also has a 6% sales tax with a higher 9% rate on alcoholic beverages!)

When deciding where to live, and this is a common concern of folks who have retired early and have that flexibility, it’s important to look at all taxes in an area.

There are seven states with no personal income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) and two more that only tax interest and dividend income (Tennessee and New Hampshire).

There are five states with no state sales tax (Alaska, Delaware, Montana, New Hampshire, Oregon) but local municipalities may charge a sales tax.

Donor advised funds & stock winners

If you routinely donate money to charities, there is a better way to do it other than giving straight cash. (if you opt to donate items rather than money, donor-advised funds won’t help)

The two most efficient ways are to start a donor-advised fund and/or donate stock winners.

A donor-advised fund is like a philanthropic or charitable savings account. You make cash or asset (securities) contributions to the fund whenever you want. Those contributions are tax-deductible as charitable donations. Then, whenever you like, you can recommend grants to your favorite charities. While the money sits in the account, it can be invested in various instruments so it can continue to grow.

The benefit of a donor-advised fund is that your donation and your grants don’t happen at the same time. If you have a high-income year, you may want to increase your charitable donations since the tax benefit is higher (you’re in a higher tax bracket). Your donor-advised fund can continue to make grants on a regular schedule.

The second way is to stocks with significant unrealized gains. When you donate appreciated stock, you claim the market value of the shares as a charitable contribution. If you were to sell the shares, you’d have to pay capital gains on the gain and the charity gets less than it would.

Here’s where the magic happens – you can donate stock to your donor-advised funds. You can make one big donation, which may be larger than what you want to give to any single charity, and then multiple grants to those charities. It makes tax sense and it makes logistics a lot easier, especially if the charity is not equipped to handle donations of stock.

(Life) Insurance Proceeds Aren’t Taxed

If you, as the beneficiary, receive life insurance proceeds, it is not considered income and you do not need to report them. When insurance salespeople tout the tax benefits of life insurance, this is what they’re talking about.

Life insurance comes in essentially two major flavors – term and whole. Term life insurance is “pure” life insurance. You get a policy that has a set term (X years) and a set death benefit and pay a monthly or annual premium. An example is a $1,000,000 30-year term life insurance policy. If you make your premium payments and die within the next 30 years, your beneficiary will get a million bucks tax-free.

Whole life insurance is a little trickier because there’s no set time period, it’s lifelong coverage and has a cash value because of the investing component. With whole life, you can borrow against it (since it has value). There is still a death benefit, the cash value grows because of the investment component, and the premium doesn’t change. It’s often more expensive than term because you accumulate cash value (and term is “temporary” in that it expires valueless after the term).

Whole life insurance offers you the ability to shelter some of your wealth from the estate tax. By paying the premiums, you are taking the money and moving it into the cash value of the whole life insurance policy. You still pay, since the whole life policy will have fees and whatnot, but it’s likely less than the estate tax.

(if you want to dig a little deeper into estate taxes, understanding the gift tax is the first step)

Keep Good Home Records

When you sell your primary residence, you do not have to to pay $250,000 of capital gains. If you are married, you don’t have to pay $500,000 of capital gains.

A lot of real estate investors take advantage of this rule because your primary residence is determined by where you’ve lived for two out of the last five years. If you’ve lived someplace for two out of the last five years, then it can be considered a primary residence. (the only exception to this is if you took advantage of this tax break in the two years leading up to the sale)

An investor will buy a house they hope to flip, live in it for two years while they renovate it, and then sell it for a tax-free gain.

Keep very good records of your home repairs, maintenance, and improvements. Repairs and maintenance are not deductible but home improvements are. The difference between maintenance and improvement is that improvements increase the value of your home. Repairs and maintenance are things that keep your home in good working order.

Final Thoughts

You may not be able to take advantage of many of these tax secrets today but keep them in the back of your mind. There may come a time when they will come in very handy. 🙂

As for today, here are 50 fun tax facts to help distract you!