Capital Gains Tax 101 For High Income Earners
Pros and Cons Of Capital Gains Tax
One of the most overlooked areas high-income professionals seem to miss when developing a financial plan involves TAXES.
Why? Because taxes are NO fun (unless you’re a CPA) and who wants to focus on an expense, right?
As a high income earner, your largest expense during your career is going to be income tax (active income).
This is the income that you trade your time for each day. Sounds like fun, right?
As a young doc fresh out of training and full of energy, we think, “Taxes? Who cares about taxes? I’m going to be a RICH doctor! I’ll make plenty of money to buy whatever I want and pay my taxes with no problemo!”
But what happens when we get a bit older and somewhat wiser? We start to think, “Taxes? Yeah, it’s something that maybe I should start to look at. I don’t really know much about them as my CPA has always done ’em for me. Maybe it’s time to take it upon myself to figure out that tax code thing.”
Want To Build Wealth?
If you want to build wealth, real wealth then listen up.
I don’t care at what point of your career you’re at now; but you have a choice to make.
Option #1 or #2?
- Continue to work HARD for your money (trading time for it)
- Have your money work HARD for you
Which is it?
Don’t worry. You’re not going to be graded as there is no right or wrong answer.
It all comes down to personal preference. If you want to work for another 30+ years and don’t mind residing in the 40+% tax bracket then, by all means, choose Option #1.
If you want to work SMARTER and not necessarily harder, then #2 is your choice.
It all boils down to how you handle your money and not just taxes.
Let’s dive in…
Assets vs Liabilities
I realize that we need to discuss the pros and cons of capital gains tax but stay with me while I make a few points first.
I think it was Robert Kiyosaki that said, “If you want to be rich, start spending your money on assets — things that make you money over time.”
Maybe it was Grant Cardone?
Doesn’t matter. The point is that what you spend your money on makes a BIG difference on your taxes.
If you purchase an asset such as real estate, you can LOWER your taxes via depreciation.
You can’t do that when you purchase a new AMG. Sorry!
Let’s take a look at some things you should focus on investing in while others you should avoid.
The Best Assets For High-Income Earners
I’m BIG on trying to better myself both personally and professionally. One of my favorite past times is reading and listening to podcasts.
Here’s a list of some of my favorite assets that have paid off in the long run:
- Books on personal finance, investing, real estate etc.
- Conferences in my field of work (dental surgery)
- Online courses
- Real estate syndications
- Index funds
- Healthy food
The Worst Liabilities to Avoid
Just because you make a lot of money, it doesn’t give you a free pass to buy whatever you WANT when you’re serious about building wealth.
- The Doctor house
- Every new tech gadget that hits the market
- Expensive cars, boats, ATVs
- High dollar clothes, watches, accessories, etc (items that make you LOOK rich even though you’re not)
When You “Can” Buy Liabilities
If you chose Option #2 above then remember, I want you to work smarter and not harder. Life’s too short.
Do I want you to have everything on the Liability list above? Yes, if you do too. But I want you to purchase them how the rich do and NOT the poor.
The key is to buy these liabilities with money you’ve made from your money (passive income), not your actual money (active income) yourself.
Does that make sense?
Here’s a video that explains it from Grant Cardone geared toward the high-income folks (rappers, ball players, doctors, etc)
He teaches that, “Instead of spending your money (active income) on Rollies, Pateks, Lambos, Richards and other BS, use your investment income to purchase instead.”
Make Your Money Work For You
Proverbs 21:20 – “The wise store up choice food and olive oil, but fools gulp theirs down.”
Unfortunately, most of the physicians and dentists I know only know how to make money treating patients.
They haven’t ever taken the time to learn how to make money work for them.
The #3 wealth lesson out of 7 in George Clason’s book, The Richest Man in Babylon, is to “make thy gold multiply.”
The point he’s trying to make is that we should treat each dollar as our own “worker” as it has the ability to produce other workers. We want them to multiply thus having THEM work hard and NOT us.
This reminds me of a quote from Shark Tank’s Kevin O’Leary, “Money is my military, each dollar a soldier. I never send my money into battle unprepared and undefended. I send it to conquer and take currency prisoner and bring it back to me.”
Basically, every dollar is like a small seed that can we can plant and will eventually sprout more dollars.
This is the essence of having “money work for you.”
How Does This Lower My Taxes?
Now that we understand in order to work smarter and NOT harder, we must make our money work FOR us.
- So how do we do this?
- How does it help our taxes?
I want to help you do BOTH, free up your time and also lower your bill to Uncle Sam.
Think about all of the taxes you currently pay. I’m not talking about sales tax, property tax, occupancy tax or income tax.
I’m focusing more so on investments.
Let’s say you want to invest in a Vanguard Index fund such as the Total Stock Market Index Fund (VTSAX).
If this is outside of a retirement account, you’d have to pay income tax on your wages first, then invest. If you’re like most, in order to invest $1,000, then you’d have to make about $1,400 (40% tax bracket).
Once you start taking money out, you have to pay capital gains tax. There’s another tax.
Then when you exit this world, the government hits you again with an inheritance tax.
So if we’re taxed literally to death our entire lives, don’t you think it’s smart to want to try to do something about it now while we can still enjoy ourselves? I do.
Our main focus should be on purchasing assets now, during our working careers, that allow us to begin to build passive income to replace our expenses.
It’s the passive income that we should focus on as the IRS treats it differently than your active income. When I say differently, I mean that it’s taxed at a MUCH lower rate than what you’re used to.
Which brings us back to the subject of capital gains and the pros and cons of capital gains tax.
What is Capital Gain Tax?
According to Investopedia, a capital gain occurs when you sell an asset for more than you paid for it.
Capital Gain = Selling Price−Purchase Price
Just as the government wants a cut of your income, it also expects a cut when you realize a profit on your investments. That cut is the capital gains tax. Didn’t I tell you that we were going to be taxed to death!
According to IRS.gov, almost everything you own and use for personal or investment purposes is a capital asset.
- your home
- personal-use items like household furnishings
- stocks or bonds held as investments
How much these gains are taxed depends on how long you held the asset before selling.
What Is Short-Term Capital Gains Tax?
Short-term capital gains are taxed as though they are ordinary income.
What this means is any profits received from the sale of an asset you held for one year or less is taxed at your normal income tax rate.
What Is Long-Term Capital Gains Tax?
Long-term capital gains tax are based on profits received from the sale of an asset you held for more than a year.
Depending on your taxable income and filing status, the long-term capital gains tax rate is 0%, 15% or 20%.
The 2020 Capital Gains Tax Brackets
|Long-Term Capital Gains Tax Rate||Single Filers (Taxable Income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|20%||Over $441,550||Over $496,600||Over $469,050||Over $248,300|
Image source – IRS.gov
From the chart above, most high income earners typically fall into the 15% or 20% categories.
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Capital Gains Example
I like to play a game with my kids that involves picking stocks based on past values.
So for instance, I’d say, “Kids, here’s three different stocks. Which would you invest in ten years ago with $1,000?”
After they pick, I then reveal the current stock price. Some are HUGE wins and some aren’t. The point I’m trying to get across to them is that it’s nothing more than a guess.
So let’s play a different version of the game with you.
Let’s say you lucked up and bought 100 shares of Tesla stock (TSLA) at $20 each. You noticed less than a year after purchasing, your investment took off like a “rocket” and you wanted to sell.
But then you remembered reading this article regarding the pros and cons of capital gains tax and decided to hold off until just over a year.
Great news! You sold your original investment for $1,000 per share! Now let’s assume you fall into the 15% long-term capital gains tax category.
The table below summarizes how your gains are affected.
|HOW CAPITAL GAINS AFFECT EARNINGS|
|Bought 100 shares @ $20||$2,000|
|Sold 100 shares @ $1000||$100,000|
|Capital gain taxed @ 15%||$14,700|
|Profit after tax||$83,300|
In the above example, you have to give $14,700 of your profit back to Uncle Sam. He’s going to get his, trust me.
But remember it could have been worse if you’d have followed your initial reaction and sold the stock less than a year after purchasing.
In that situation, your profit would have been taxed at your ordinary income tax rate (short term capital gains tax), which can be as high as 37% or $36,260.
Pros and Cons Of Capital Gains Tax
Whenever it comes to the subject of taxes, it’s always best to check with your CPA or real estate attorney.
Thus far, we’ve learned that:
Capital Gain = Selling Price − Purchase Price
A capital-gains tax is assessed when a capital asset is sold for profit.
Depending on an investor’s individual tax needs, many utilize strategic techniques for either taking a capital gain or loss.
It’s for this reason that capital gains taxes can have both pros and cons.
Pro – Tax deferment
One of the reasons I love being a real estate investor has to do with taxes. Specifically the deferment of those little critters. As a real estate investor, you don’t pay taxes on the equity gained until the year that the property sells (for a profit).
Likewise, an investor that purchases stocks, bonds or mutual funds doesn’t pay until either the assets are sold or a distribution is taken.
Think about your income tax. Uncle Sam wants it EVERY year. It’s gotten so large for us that we pay monthly just to be able to stomach it. 🙁
Con – Reduced profits
The IRS classifies a capital asset as basically everything you own for personal use or investment purposes.
As we’ve learned today, we’re taxed whenever these assets are sold for a profit.
The disadvantage of this tax is that it can reduce the overall profits realized from the sale of the asset.
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