If you live in Canada or the US, the tax system is progressive. This means that the more you earn, you generally pay more in taxes. This is true if you’re an employee and if you’re self-employed or operate your business through a flow-through entity such as an LLC or S-Corp.
However, not all income is taxed equally. Employment income and self-employment income is taxed at a maximum US federal tax rate of 39.6% and at a maximum tax rate of around 50% in Canada (depending on the province that you live in).
Capital gains receive preferential treatment in Canada and the US. They are taxed at a maximum US federal tax rate of 23.8% and a maximum rate of around 25% in Canada.
Dividends (Qualified dividends) are taxed at a maximum US federal tax rate of 23.8% in the US. They also receive preferential treatment in Canada.
Rental real estate is a great way to shelter income. You can deduct expenses against rental revenue. You also get to claim depreciation each year which reduces the income subject to tax. You can claim depreciation on your rental building even when its actually value may be going up. Eventually you have to recapture this income but you won’t have to do this until you sell, so you get a tax-deferral. Depreciation expense is also a non-cash charge meaning cash isn’t actually going out the door. The sale of a rental property can result in a capital gain which results in preferential tax rates (see capital gains tax rates above).
So what’s the impact of the above?
The tax systems in Canada and the US punish laborers and reward investors. They also punish people who are consumption oriented because they need to keep earning employment income to help sustain their spending habits For example, think of a lawyer earning $300,000 per year. The lawyer forks over almost half of her income in taxes (income taxes and Social Security taxes). The lawyer isn’t disciplined and spends nearly all of her income each year. So what happens is that the lawyer is stuck on the so-called hamster wheel as she never really gets ahead. The government takes half of her money and her consumption-orientation makes it even worse.
So what do the rich do?
For one, they weren’t heavily consumption-oriented when they were accumulating their wealth. Remember Golden Rule #1 – Spend Less Than You Earn. This allowed them to buy assets.
When they’re building their fortune, they focus on investments that are tax-efficient. This includes:
- Stocks that don’t pay dividends (think Berkshire Hathaway). You get to defer taxes until you sell while at the same time your investment increases in value each year – what a sweet deal.
- They put stocks in tax-deferred accounts such as TFSAs, RRSPs, IRAs, ROTH IRAs, 401(K)s, and SEP IRAs. This provides a long tax-sheltered compounding period. By stuffing your tax-sheltered accounts with great investments, you can build a fortune. For example, if you invest $100,000 for 25 years, earn a return of 7%, and pay taxes at a rate of 15%, you should have $424,154 at the end. But if your tax rate is 0%, you’re left with $542,753 – a huge difference.
- They purchase rental real estate and claim all allowable expenses and depreciation to minimize taxes. Depreciation is a non-cash charge so there’s no loss in cash flow. They do this while the value of their properties increase over time. By paying little or no taxes on this income, you can take your surplus and other savings and invest in more rental properties – eventually creating a portfolio of properties.
What’s the result of this?
You can have a high-powered lawyer earning $300,000 who looks rich on the surface but when you dig deeper, the lawyer has no assets because she’s been punished by the tax system and her consumption-oriented lifestyle.
While at the same time, you can have a lawyer earning the same or less who spends less than she earns and invests the excess in stocks and real estate. She’s earning tax-efficient income. Over the years, she builds a substantial stock and real estate portfolio. She decides she doesn’t want to work anymore. After she quits work, she’s paying much less in taxes than the $300,000 lawyer still working. Her net income on her tax return is also probably a lot less than the $300,000 lawyer. But when you dig deep what you see is a substantial investment portfolio with stocks stuffed into tax-sheltered accounts and rental real estate that has appreciated significantly in value. If you just look at income, the $300,000 lawyer looks much richer. But the truth is that the retired lawyer is much wealthier as she has accumulated substantial assets because of disciplined saving. But one of the reasons she has stayed wealthy is because she’s invested in investments that are tax-efficient so she’s paying less to the taxman – she has more leftover to invest.
The lesson: The Canadian and US tax systems reward investors. You can start out as an employee or business owner but your goal should be to move into the investor class if you eventually want to become financially free and stay that way.