Blog |

Not All Income Is Created Equal

Who pays the most in taxes and how to pay the least

When I was a kid looking for ways to make money, I didn’t really care much about how or where I got it. I was just as happy (perhaps even happier) getting an allowance from my parents as I was earning money for shoveling snow in the winter or mowing lawns in the summer. I never distinguished between types of income because the end result to me was always the same—cash in my pocket. Of course, back then I never earned enough money to worry about paying taxes. It didn’t really matter how I got it, just so long as I had enough to buy candy or a baseball glove, or, later on, go on a date with a pretty girl (my favorite use for money in high school).

These days I care a lot about how I earn my money. And my favorite income is naturally the nontaxable variety. My least favorite income is the type that requires not only income tax but also other taxes such as employment taxes.

Three types of income

In every country, there are different types of income, and they all have different associated tax rates, costs, and benefits.

1. Earned income: If you are an employee, a self-employed individual or a partner, you make your money through earned income. Earned income is taxed at the highest rate possible.

2. Portfolio income: Where earned income is acquired by exchanging time for money, portfolio income is made through capital gains.

3. Passive Income: Generally derived from real estate, royalties, and distributions. It is the lowest-taxed income, with many tax benefits, and is the easiest income to build wealth with thanks to its combination of low taxes and potentially infinite returns.

The point is this: not all income is created equal. Passive income, the kind of income generated on the right side of the quadrant is much better than earned income, the kind earned on the left side of the quadrant. Passive income is taxed less, and it's also a result of cash-flowing assets, not selling your time as an employee.

Convert ordinary income into passive income

Many people start their lives earning money like I did, by doing a job and getting paid for it. The key to growing your wealth, however, is by converting your ordinary income into passive income to lower your tax rate.

For example, my friend owns the restaurant, Chez Pierre. Suppose he earns $200,000 after his normal expenses through his restaurant this year. If he took all of that money out of the business, it would be taxed at regular rates. He doesn’t want to do that. So instead, let’s say he puts $80,000 back into the business in the form of additional supplies and equipment that will make even more income for him in the future and then puts another $20,000 into marketing.

All of the money Pierre puts back into his business is deductible against his $200,000 of income. That would leave him with $100,000. Now let’s say that he has a home office and that his van is used primarily for business; that when he spent money on a vacation, he took his wife and children, who are all owners of the business with him and that they spent more than half of each weekday on business; and that whenever Pierre and his wife went to dinner during the year, they had a business discussion.

In total, Pierre could easily have another $30,000 in expenses that he could use to offset his income. That leaves only $70,000 to be taxed. And after his deductions for his mortgage, taxes, and charitable donations, he’s down to $40,000 of taxable income. And after his personal exemptions, he’s down to less than $20,000. If he’s in the United States, this $20,000 will be taxed at a 10 percent rate. So he only has to pay $2,000 in taxes on $200,000 of income. If he were an employee on the left side of the CASHFLOW Quadrant making a salary of $200,000, even after he took his deductions for mortgage interest, taxes, charitable donations, and personal exemptions, he would’ve paid a tax rate of about 20 percent on the remaining $150,000—that’s $30,000.

Understanding how the different types of income are taxed will help you so that you can have a real discussion with your accountant and so that you can keep a lookout for the good, better, and best types of income (i.e., those with the lowest taxes). Even if you aren’t good at math or at keeping track of things like this, you can still have all of the advantages of low-taxed income just by having the right people on your team and finding a great accountant to assist you.

To learn more about lowering your taxes, get my book Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes