Can You Avoid Paying Income Tax?

Elon Musk is depressed from overwork, just like many American his age. This is why your life goal should be to strive for full financial freedom by creating enough income streams such that your needs are fully met without you having to devote your time to it.

If you’ve read my book, you’ll know that I’ve identified being a digital nomad operating your own online business as one of the best ways to achieve that end. While I was pondering this, I wondered if there was a loophole in the system, a backdoor lifehack to circumvent existing laws regarding residence, territoriality, and taxation. That is, can you avoid paying all income tax completely?

As it turns out, others have wondered the same thing. Basically, most countries will not tax you if you haven’t lived in that country for a certain amount of time to qualify for residence. Usually it’s something close to  less than half of the calendar year. By staying below that level,  you avoid being considered a tax resident of that country. The US is a little different, being one of only two countries (along with Eritrea) to tax you on worldwide income regardless of residence, though it does give a foreign earned income exclusion.

The loophole is due to laws regarding residence and taxation that have not yet caught up with modern innovations in travel, communication, and technology. Before with income tied to jobs which were tied to location, countries can get their share of tax from your employer or from you based on your residence (if you operated a small business, for instance). However, now we have online web businesses that we can run from anywhere in the world. If governments can’t tax us at the source of production (because the business is “based” in a tax haven) or by residence (due to the digital nomad being constantly on the roam, never staying long enough in any country to gain residence), we’re free from all income tax.

As an example, let’s take a British citizen who wants to start a web business offering cultural sensitivity consulting to large established companies. This adventurous individual incorporates in Bermuda or the Cayman Islands, and then proceeds to travel the world, never staying long enough in any single place to owe taxes. This is made easy with visa free access to many of the world’s most fun destinations, and eventually our nomad settles on a regular cycle of Ireland -> Thailand -> Singapore -> Australia -> Panama -> Ireland. Meanwhile, all the web income generated from work done remotely is not subject to tax in any of the countries visited, since the corporate income is categorized as earned in the tax haven.

Let’s celebrate this with a Joan Baez song glorifying the joy of avoiding taxes:

 

Facebooktwittergoogle_plusmail

Take More Risk in Tax Advantage Accounts

The Bond King Bill Gross likes to philosophize about profound emotions such as joy and melancholy in his investment rants, and this post is driven in part by the emotion of regret seeing Bitcoin hit all time highs, and even surpassing the price of gold.

Such is the case for many in my field. When I was finishing my last year at Berkeley, I came upon news reports of the fancy new cryptocurrency idea called Bitcoin. Independently at the same time, so did my fiancee’s brother, childhood friend, and cousin-in law (all techies). We didn’t think much of it, and as risk averse as I was, I didn’t even bother putting $50 or so of play money into there. If I did, it would be worth almost a million! Similarly, my fiancee’s aunt regrets not buying Apple stock when it was down in the dumpster right before Jobs took over (seriously, most smart money was on the company going bankrupt, not staging a phoenix-like revival).

While we can all regret not doing the most “optimal” thing (life doesn’t have a save/reload button) in hindsight, we can also never with certainty predict what the future will hold. What we can do, and it will sound boring, is to make sure we have the right types of investments in the right places, and to stay allocated to assets in a way that allows us to sleep well at night. If we do dedicate a small (e.g. 5%) portion of our portfolio to lottery ticket bets on small cap stocks, that’s fine. Just make sure to do it in the tax advantaged section of the portfolio.

Standard portfolio theory suggests that we should make sure that our money is invested in the way that takes advantage of legal tax shelters to our benefit, as much as possible. Just to recap, there are in general three big categories of holdings: taxable, pre-tax 401k/IRA, and Roth 401k/IRA. Here’s what we should put in each:

  • Taxable: The goal here is to hold for as long as possible and to minimize the number of transactions and income generated, since each sale can generate a huge tax bill for capital gains. The best choice is a low fee total stock market index fund (Vanguard, iShares, and Schwab are all good choices) that is held and not sold until death. Then we can take advantage of the tax free basis step up when we bequeath to heirs. The small amount of dividends generated is taxable, yes, but at a much lower rate than the marginal rate. Bond holdings should be in tax-free municipal bonds as much as possible, doubly so if you’re in a high tax bracket.
  • Pre-Tax: We have to pay tax on the whole thing anyway but not until we cash the money out from the account. That quirk makes pre-tax accounts ideal for traders, stock pickers, and market timers who move in and out of positions with regularity. It’s also a good place to stash taxable bond funds and high dividend funds that throw out a lot of periodic income.
  • Roth: This is where you should make your highest risk “lottery” type bets. Let’s say you could (and want to) invest in bitcoin, startups in their infancy, micro cap stocks, penny/value stocks, turnaround stories, Greek bonds on the verge of default, and foreclosed homes. You would do so here. The bigger the potential gains, the better it will be. Whether you stumble upon a 10-bagger or 100-bagger doesn’t matter. You won’t pay any tax on it at the end.

So in summary, you want to use the right tool for the job. A balanced portfolio should consist of stock funds, bond funds, and maybe a dash of play money. Instead of making each tax category holding the same, we should concentrate our investments in the type of account that is best-suited from a tax perspective. Big gainers should be in the Roth, slow steady accumulator broad market funds should be in taxable, and income spewing investments in the pre-tax account.

Facebooktwittergoogle_plusmail

Can You Pay Taxes Like Donald Trump?

Donald Trump’s 1995 tax return revelations are all over the news. Some think it’s a smart play, while others think are incredulous that he can get away with paying so little. I’m not here to judge morality or try to sway you with respect to politics. Instead, there are things we can learn from the man in how to structure our own taxes so that we can only pay as much as we’re legally required to, as many defend him for doing. Many of these tips are covered in detail in my book, if you’re interested.

  1. Earn your income from capital gains and dividends, rather than from wages. Working doesn’t pay anymore. Returns from existing wealth and investments are taxed at much lower rates, with a cap of 15-20%, with a surcharge for high earners. Oh, there are no payroll taxes charged on investment income.
  2. Write off “business” expenses and losses and take advantage of generous categorizations of housing depreciation as losses. Offset as much business income with expenses and deductions as possible.
  3. Take advantage of legal tax shelters like IRAs and 401ks. In this category I would also include HSAs and 527 plans. Remember that if you’re self-employed, you can shelter up to $53,000 in income rather than the $18,000 401k limit.
  4. Use the backdoor Roth. I’ve written about it before.

Lest you forget, Mitt Romney used these very tricks to pay a 14% income tax. To do the same, you have to earn your money in the same fashion and from the same sources as these billionaires.

Facebooktwittergoogle_plusmail

Voting With Your Feet

In time for tax season, many of us are probably grumbling about how much tax we have to pay. Sure, the headline rates for the US may not seem all that impressive, but when you add up state, local, payroll, and federal tax all together, the marginal rate can be in excess of 50%! That’s higher than the top rate in the UK. On top of that, we don’t even get free health care, efficient public transportation, or cheap schooling. Think of having to pay out of pocket for those mandatory things as an extra tax on the little guy.

Could it be then that the US is the most heavily taxed country in the world? Something to think about for sure.

One example from recent times is the St. Louis Rams moving from St. Louis to Los Angeles. While some employees will enjoy the weather, others may bemoan the pay cut that they’ve just received from the change in state tax systems. That’s not to mention the higher cost of living in California. Strangely enough, so many people try to live and work in California (high supply), compared to the cold and dreary Midwest, that salaries for comparable professions are higher in the Midwest even before cost of living adjustments.

It’s no surprise then that I’m planning to leave California as soon as I am able.

In any case, while we could stay and try to fight the man through lobbying or voting, it’s hard for a single person to make a difference. That’s where we can vote with our feet. Just like Tiger Woods did and what Phil Mickelson pondered about doing, we can leave high tax locales and move to low (or no) tax ones. The name of this game is geographic arbitrage, which I go into detail in my book on wealth.

 

Facebooktwittergoogle_plusmail

Turbocharge Your Retirement with the “Backdoor” Roth

For those of you who have read my guide to wealth, you’ll remember that one of my points of emphasis is to save for retirement. Tax-deferred (traditional) and tax-free (Roth) 401k and IRA accounts allow us to minimize the taxes we pay in a legal manner. This allows our earnings to compound and grow faster than they would in a taxable brokerage account. Of the two, I like the Roth as it takes away all future tax headache as everything inside is tax exempt forever! It also has many advantages when drawing down (no required distributions) and as part of an estate package (automatic step up in basis).

Unfortunately, the government recognizes that the Roth IRA offers such good benefits that it has built in strict income eligibility thresholds. Singles making more than about $130,000, and married folks making more than about $190,000 can’t put anything into a Roth IRA. A Roth 401k remains a (great) option, but not all employers offer it.

For those who don’t qualify or are otherwise prohibited from contributing to a Roth IRA, we need to go in through the back door. Here are the step by step instructions:

  1. Open a traditional IRA
  2. Make a nondeductible (after-tax) contribution of $5,000 or $6,500 (depending on age), but don’t buy anything with the money yet
  3. Immediately convert the account into a Roth IRA
  4. Invest the money

Voila. Absolutely no difference in the end between this and a direct Roth IRA contribution. The back door approach exploits the loophole that tradition -> Roth IRA conversions don’t have the same income eligibility limits that Roth IRA contributions do. Now anyone without regard for income can take advantage of the great features of the Roth IRA.

Should you take advantage of this? The general rules of traditional vs Roth apply. If you plan on becoming wealthy in the future with the help of my book, you will have plenty of income-generating assets. Having as much of your wealth sheltered from tax in Roth IRAs helps to optimize your tax situation in that setting.

Keep in mind one big gotcha. If you have a large traditional IRA with a mix of deductible and nondeductible contributions, the “pro-rata” rule comes into effect. This means that you can’t just choose to convert only the nondeductible portion. If you have a $10,000 IRA with half of it as deductible (pre-tax) and the other half nondeductible (after-tax), a conversion of $5,000 will incur tax on $2,500. The best workaround is to keep the size of the IRA small and convert all of your contributions each year, or suck it up and convert the whole IRA.

Keep in mind that the pro-rata rule doesn’t apply to our 401k investments. This may be one situation where it’s advantageous to hold off on rolling over the 401k to an IRA when we change jobs.

Facebooktwittergoogle_plusmail