…through long term cap gains and dividends. If earning $73,800 per year (married filing jointly) or $36900 (filing single) and PAYING NO TAXES interests you, then please do read on for an interesting story. I will explain why lots of financial independence(FI) bloggers use investment income as a vehicle for their FI journey.

Many years ago, I remember Warren Buffett mentioning that he pays a lower tax rate that his secretary. I never really figured out what he meant until I started exploring financial independence myself and started investing in stocks myself. To understand his statement, one needs to understand some part of the income tax code….I know, not a popular topic, but knowing a little bit of the tax code can save you lots of money in taxes!! So, bear with me.

Types of Income

There are many types of income a person can earn. Some types are listed below:

• From working for somebody
  • Salary
• From owning stocks and bonds
  • Long and short term capital gains
  • Dividend Income
• From owning real estate
  • Rental income
  • REIT funds income
• From cash
  • Interest income from banks

Types of Income according to IRS

The tax man has a different notion of income. The tax man sets the amount of taxes based on the different notions of income. So, let us understand the types of income a tax man sees.

• Ordinary Income
  • Salary
  • Short term capital gains (from selling stock owned less than a year)
  • REIT income
• Ordinary Dividend Income
  • Owning non-qualified stocks that pay a dividend
• Qualified Dividend Income
  • Owning qualified stocks that pay a dividend
• Long term Capital Gains
  • from selling stock owned more than a year

The simple definition of Qualified dividends means income from corporations that meet a specific criterion like incorporated in the US or in a country that has a tax treaty with the US, stocks owned more than 60 days prior to the ex-dividend date, etc etc. There is a link at the bottom of this article for details. But, dividends from most US corporations are Qualified dividends.

Tax Filing Status

The tax man also specifies a filing status based on the different social definitions attached to a person.

• Single
• Head of Household
• Married
  • filing jointly
  • filing separately
• Qualifying Widow or Widower

IRS Tax Rates for the types of Income

Since the tax man sees income differently than you and me see it and different filing status, the tax rates are different for the different types of income. For 2014, let us consider the following table for two of the most common filing status types.

Tax Rates		Single		Married Filing Jointly / Qualifying Widow or Widower
Ordinary Income	Long Term Capital Gains and Qualified Dividends	Taxable Income over	to	Taxable Income over	to
10%	0%	$0	$9,075	$0	$18,150
15%	0%	9,075	36,900	18,150	73,800
25%	15%	36,900	89,350	73,800	148,850
28%	15%	89,350	186,350	148,850	226,850
33%	15%	186,350	405,100	226,850	405,100
35%	15%	405,100	406,750	405,100	457,600
39.6%	20%	406,750	—	457,600	—

The most important rows to consider are the rows in BLUE color. Two things stand out in the blue rows

• 0% tax rate for
  • Long term capital gains
  • Qualified dividends
• 0% tax rate until…
  • $73800 for married filing jointly
  • $36900 for single filers

What the above powerful statements tell us is that if *ALL* of your income comes from long term cap gains OR from qualified dividend, you will pay ZILCH to the tax man i.e. you get to keep what you earn!! How beautiful is that!

Back to Warren Buffet and his secretary…

You did not think I forgot about him did you 🙂 According to some news articles, Warren Buffet himself declares that he pays a 17.4 percent rate on taxable income. Note that he earns millions of dollars in income, but the first $73800 is tax free. His secretary apparently pays 8-9 points above him i.e. her average tax rate is atleast 25%. How is this possible? This is possible because of this:

• Warren Buffett
  • most income is Investment income
  • Taxed at lower rates
  • First $73800 of investment income is tax free
• His Secretary
  • most income is Salary income
  • Taxed at a much higher rate (from the table about, it is 25%)

Conclusion

Most financial independence bloggers, when they achieve financial independence and retire early, expect to get income from two sources

• Stock investment
  • selling stocks and realizing long term capital gains
  • qualified dividend income
• Rental income

If you are in the stocks category, like I am trying to be, aim for a good chunk of income from Investment income and get to keep all of the income until $73800 (married filing jointly) or $36900 (single filers).

It would be good to diversify the income streams and get some rental income as well. But, that is not my chosen path yet because of lack of hard $cash$.

Go Investment Income!!

Links

• Qualified Dividends
• Tax rates for 2014