…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
- 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
- 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.
- Head of Household
- 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|
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%)
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!!