The people's voice of reason
The people's voice of reason
Some say the rich don’t pay taxes. Whether or not this is true, it seems as though the well-to-do keep a detailed playbook for holding much of their wealth out of the tax man’s reach. How do they do it? Diving into tax laws may not be everyone’s cup of tea, but it’s how savvy wealth-builders unearth strategies for hanging on to their assets.
Below, Finder.com breaks down some of these tactics and whether they might work for you.
Above a certain income level, corporations have it easier, at least by income tax standards.
Personal income tax rates are around 10%-20% for low earners in both the U.S. and Canada, and high earners could pay up to 50% or more in tax.
On the other hand, corporate income tax rates start around 21% in the U.S. and 9% in Canada, and peak at around 30%.
It’s possible to save thousands of dollars by creating a corporation and classifying your earnings as business income so you can pay income tax at a more favorable rate. Not everyone can use this strategy, though, and the rules can get complicated.
How it works
To create a corporation, you’ll need to spend at least several hundred dollars in filing fees, plus up to thousands more for lawyers and other initial costs. Expect to pay hundreds of dollars annually in reporting fees.
Once you’re set up, you can begin earning income under your corporation’s name.
The rules vary based on where you’re incorporated and the type of corporate structure you have, but you can often access money by paying out salaries, bonuses or dividends.
Under specific circumstances, you may also be able to pay income to family members who are in a lower tax bracket, provided they are legitimately tied to the business.
Of course, money paid out of a corporation to individuals is still taxed at the personal income tax rate. But whatever you don’t reasonably need for living costs can be kept within the business, grown through investment and taxed at a lower corporate rate.
Corporate tax bills can be lowered even further by deducting expenses such as:
Put simply, you do the same work you’ve always done, but for a corporation you own, which lets you access a heap of tax benefits.
What’s the catch?
If incorporating can be so advantageous, why isn’t everyone employed under their own corporation?
Salaried employees cannot count their earnings as business income (in Canada, doing so may even trigger a high tax rate). This is to ensure that corporate tax benefits are used to stimulate the economy, not avoid personal income tax.
So you have to choose between being salaried and free from the burden of business administration or running your own business and paying yourself.
Another potential barrier to incorporating is that you’ll only save money if you earn more than you need to live, so you can afford to leave money in the business and avoid withdrawing it for personal use.
Some estimates put the point at which you may want to consider incorporating at well over $100,000 a year (or possibly as low as $60,000 a year in Canada).
Speak with an accountant or lawyer to decide if this tax-saving strategy is right for you.
Watching your wealth grow is exciting. But that excitement dims when it comes time to pay capital gains tax on the profit you’ve made from buying and selling assets.
It turns out that you may not have to choose between holding on to your assets to avoid capital gains tax and cashing in on their value.
The well-to-do have discovered an alternative way of tapping into the value of their assets by using them to get loans, which can be used for just about anything and aren’t subject to income tax.
Upon death, it may be possible to transfer collateral assets to a beneficiary without paying capital gains tax.
This is known as the “buy, borrow, die” strategy.
How it works
Use your money to buy assets—stocks, property, artwork, collectibles, vehicles or anything else a lender might find valuable. Then take out loans or lines of credit secured by the assets you bought.
Money you borrow must be repaid, so it’s typically not viewed as taxable income. And because you still own the assets (they haven’t been sold or disposed of), you won’t need to worry about capital gains tax.
However, capital gains/losses kick in when you sell your assets. That’s why you might want to hold them until you die, then bequeath them to someone else. In the U.S., the inheritor only pays capital gains tax when they dispose of an asset for more than it was worth when they inherited it—capital gains are not calculated on the original purchase price.
This is huge.
Say you buy a home that increases in value by $200,000 by the time you die. A loved one inherits your home and sells it for $25,000 above the current market value. Under U.S. law, they only have to pay capital gains tax on $25,000, not $225,000.
The same tax benefit doesn’t exist in Canada, but under certain conditions, assets can be transferred to beneficiaries via trusts without incurring capital gains tax.
What’s the catch?
Ultimately, the “buy, borrow, die” strategy works if the tax laws where you live allow your beneficiaries to sidestep or defer capital gains tax on profits made from selling inherited assets.
Taking a short-term view, however, extracting money from your assets in the form of tax-free cash collateralized loans is a clever way to enjoy the value of your holdings during your lifetime without surrendering too much to the tax man.
But if there’s no way to eventually sell or bequeath those assets without being hit with capital gains tax, you’ll eventually have to settle the loan and pay tax.
Investment taxes have a twofold effect: Capital gains tax takes a chunk out of your winnings, but capital losses reduce the tax you owe.
Smart investors find ways to use both gains and losses to their advantage, keeping as much of their earnings as possible in tax-sheltered entities and effecting capital losses when it’s most beneficial—a strategy known as tax-loss harvesting.
How it works
Generally, investors look to profit by selling investments that have grown in value. But doing so incurs capital gains tax.
That’s why savvy investors sometimes look for unprofitable investments they can sell at a loss to write down their taxable capital gains.
What if you want to hold on to your unprofitable investments instead of selling them? This may be the case if you’re committed to a “buy-and-hold” strategy or you think certain investments may soon rise in value.
Can you simply sell an asset to incur a capital loss and then buy it back right away to maintain your portfolio? No. Tax laws in the U.S. and Canada prohibit this.
But you may be able to sell a depreciated asset and immediately buy a similar (yet sufficiently different) asset to more or less maintain your investment strategy while remaining eligible to write off a capital loss.
What’s the catch?
The “wash-sale” rule in the U.S. and the “superficial loss” rule in Canada both place a 30-day window surrounding the sale of securities. During this time, if you buy an identical security to the one you just sold, any capital losses are ineligible to be claimed on that year’s tax return.
Where tax-loss harvesting is concerned, the question is then “How similar can a security be to the one I sold without it being considered identical?”
Unfortunately, tax authorities don’t specify an exact answer. But if you sell stocks in a company, it’s usually considered safe to:
These strategies might be impractical if you have a modest income or you’re new to investing.
But there are still ways to cut down your tax bill and put more towards savings, regardless of how much you earn (although topping up your income might be the first step to take before digging into tax optimization).
Don’t leave money on the table. Keep an eye on credits and deductions you may be able to claim for medical treatments, training and education, moving (relocating), working from home, donating to charity and other costs.
Additionally, top up your contributions to tax-advantaged accounts like 401(k) plans in the U.S. or RRSPs in Canada. These types of accounts are designed to reduce the financial burden of costly milestones like getting an education or retiring, so take full advantage of the benefits they provide.
As you wait for the right time to start implementing more complex wealth-building plays, continue learning how taxes and investments work. You might be surprised at how accessible the game plans of the financial elite are—even for those with considerably more ordinary lives.
This story was produced by Finder.com and reviewed and distributed by Stacker.
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