The formula for building wealth seems simple: Find a job, work hard, and get promoted so you earn more money. But this doesn’t account for the fact that the more money you earn, the more you’ll pay in taxes each year.
Many people try to offset those tax payments by investing in stocks or real estate, putting their paycheck to work so they can see returns far beyond their annual salary. But if you don’t fully understand how different types of income are taxed, this strategy will still ultimately fall short.
In this article, we’ll explain how understanding tax buckets can help you build a more tax efficient investment strategy, and maybe even decrease the taxes you pay on your W-2 income in the process.
What are Tax Buckets, and Why Do they Matter?
For tax purposes, the IRS separates income into three “buckets” or categories: passive income, earned/active income, and portfolio income. Since we’re going to be focusing on investments other than stocks and bonds, let’s take a look at the passive and active income buckets in particular.
Active income (also called “earned” or “ordinary” income) includes any salary you earn at a W-2 job, as well as earnings from contract or freelance work. This bucket is taxed at the highest rate of any type of income. For high wage earners, this means that you’ll be required to give more than 35% of your annual earned income to the government.
The passive income bucket includes income from real estate, which is taxed at a lower rate because of the current IRS rules related to taxes on capital gains related to passive streams of income. This is one of the reasons why real estate is such a popular asset class for high net worth individuals.
Tax Efficient Investing vs. Conventional Investment Advice
Most Accredited Investors understand that passive income is a route to earning more money while paying less taxes. For example, if your real estate portfolio generates $100,000 in rental income this year, that is more valuable than a $100,000 salary increase, because you’ll pay less taxes on the rental income.
This is a valuable insight to have when planning your investments, but it’s not the only way to reduce your taxes. Let’s think back to the two buckets we discussed earlier:
It’s important to remember that the two buckets almost never mix. So no matter how much passive income you generate through investing, it won’t decrease the amount of taxes you have to pay on your active, W-2 income.
Only certain, government-incentivized investments can actually decrease your income tax while still allowing you to earn more money.
Choose the Right Vehicle for Your Destination
As with any investment, it’s important to know where you’re trying to go, and then choose the investment that can help you get there most efficiently.
If your goal is to build wealth for yourself and for future generations, then you need to focus on making the most of the money you’re already earning, and holding onto as much of it as possible.
Our team at First Generation Capital Partners is laser focused on helping clients achieve this goal through tax efficient direct investments like the one we’ve described above. If you’re interested in learning more, please fill out this form to get in touch with us today.
Disclaimer: All income and tax figures are used strictly for illustrative purposes. Please check with your tax and legal professional as FGCPTM does not provide tax or legal advice and the above is not intended to or should be construed as such advice. Your specific circumstances may, and likely will, vary.