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Recently, ProPublica released a devastating expose on how billionaires shield their incomes from the tax man. It’s a good read and illustrates how our tax laws and codes may need to be reviewed and/or reworked. For the purposes of this posting, I will not discuss the politics of this article. I just want to focus on practical applications on how the wealthy avoid taxes in general.
TL;DR – How did they do it?
The wealthy own stocks of their companies. The value of their stocks go up. They have a huge line of credit to fund their lifestyle and use stocks as collateral. The interest rates are very low for these loans. They may make minimal payments or none at all. Rinse and repeat yearly. They die. Their stocks now step up in value and pass to their heirs largely tax-free.
Ok – How about the middle class?
The middle class can use some of these strategies to reduce their tax burden. The main thing is that if one is in the middle class, they are earning W-2 income by working for their employer. Taxes cannot be avoided on the scale that wealthy people do.
If you cannot avoid taxes, then the next best thing you can do is to reduce your tax burden. Reducing your taxes will help you increase your wealth. In 15-20 years, your wealth increases substantially to the point where you may not even need to work any more. No more W-2 income and the associated tax burdens.
The Secret Sauce
How to do it on a middle class lifestyle? Open a brokerage account. Do not skip this step. Ideally, you need to have a brokerage account with low margin rates and cash management features (i.e., check writing, ATM card…). Shop around – There are plenty of brokerages that offer such accounts. I use Interactive Brokers.
Next, you need to fund your brokerage account and buy stocks. (You can buy bonds as well, but I prefer stocks.) You need to make regular contributions and buy stocks over a period of time. Yes, the stock holdings may go down in value – they are a risky investment after all.
After accumulating shares of stocks, you should have at least $100,000 in your brokerage account. Depending on your W-2 income, savings, spending, and investment performance, it may take anywhere from 3 to 15 years just to reach this milestone. (Me? 7 years and counting… Haven’t cracked it yet!)
Generally speaking, you are able to borrow money from your brokerage account, up to 50% of the value of your stock holdings. In this case, stock holdings of $100,000 will allow you to borrow up to $50,000 to fund your lifestyle. You do this via the margin loan. You just request cash from your brokerage account. The margin loan(s) acts like a line of credit – just request what you need. You can make multiple requests over the course of a year.
The margin loans currently carry low variable interest rates. The interest rates can go up/down. I’ve been carrying a margin loan for almost a year, and my interest rate did not fluctuate that much. Interest is charged (& compounded?) on a daily basis, billed monthly.
Got my Margin Loan – Now what?
Enjoy the fruits of your labor. Travel. Improve your home. Go out and try new experiences. Enjoy the company of your loved ones and friends. Ok, you still have a loan and still have to pay it back… I feel your pain.
It’s really easy to pay off a margin loan – you can choose not to pay it. Ever. This is what wealthy people do. In our case, since we still have W-2 income, we are not wealthy yet. We need to pay some or all of it eventually.
Method #1: You don’t pay off the margin loan right away. You just let the quarterly dividends to pay off some or all of the accumulated interest on your margin loan. This is done automatically by your brokerage, when they collect dividends on your behalf. Your margin loan principal is essentially untouched and the interest compounding stops roughly every three months. The downside is that stock dividends may incur tax obligations.
Method #2: You have stocks that appreciated in value and it has been more than one year since you’ve held these shares. You need to have Spec-Id turned on for your stock holdings at your brokerage. Selling appreciated shares of stock after holding them for more than a year will gain favorable tax treatment. You sell those appreciated shares and the proceeds will be used to pay off some or all of the margin loan, including any compounded interest.
Method #3: You make your regular contributions to your brokerage account. The regular contributions come from your W-2 or other income. Instead of accumulating more shares of stock, these contributions help pay down some of the margin loan and any compounded interest.
Method #4: You’re not gonna like this one. You die. The brokerage will pay off your margin loan. Your stock holdings will step up in value on the date of your death. Your heirs may get these stock holdings and may incur little or no tax obligations.
Downsides of the Margin Loan
Yes, it is risky to invest in the stock market. A margin loan is risky in by itself – it is a loan and you still need to pay it back. The margin loan has a variable interest rate – which is another level of risk. The brokerage could liquidate some or all of the stock shares to pay off a compromised margin loan, and will not allow you chances to cure any deficiencies.
Scenario #1: The stock market dives 45-50% over several months. If you already have 50% of your stock positions held up in a margin loan, then what? The brokerage could sell off your stock holdings at a loss to satisfy some or all of this margin loan. You could incur unwanted and unplanned tax liabilities by a forced sale of your securities.
Scenario #2: The benchmark interest rate jacks up significantly over few months. It is now 8% interest, when the previous interest rate hovered around 2%. Now what? You will be paying more in interest costs. It could get expensive quickly. You may feel pressure to sell some stock shares to pay down the margin loans quicker than you’ve planned. You may incur additional tax liabilities from premature stock sales.
Scenario #3: You get involved in a car accident and caused severe injuries. The aggrieved person could sue you and wipe out your brokerage account. You may not have enough funds to pay the lawsuit, so you need to liquidate your stock holdings and pay off the margin loan. Obviously, you would need adequate insurance to protect your brokerage account.
An Alternative to Margin Loans
You can essentially accomplish the same thing by using equity from your home or other real estate. For example, you’re in your 20’s and you bought your home. You’ve been paying off the mortgage and paid it off early in 20 years. You’ve got some equity in your home.
You can tap your equity by doing a cash-out refinance. The bank will give you a huge chunk of cash upfront in return for another 15-30 year mortgage. You put this cash into your bank accounts. You enjoy the fruits of your labor that your home equity generated.
There is a benefit in using cash-out refinances; the interest rate is fixed. If you could borrow $200,000+ from your home at 2% interest rates, that would be one great deal! You do not have to deal with the uncertainty of fluctuating margin interest rates.
The downside is that you have to pay it back on a monthly basis. You cannot choose to NOT pay it off. The monthly nut is required. Secondly, it is still your home, unless you chose to refinance another property. Do you want to risk losing your home to a foreclosure due to job loss or some other catastrophe? Thirdly, you can only refinance up to 80% of the value of your home or property.
Fast Forward 20+ Years…
You should keep contributing to your investments in your brokerage account and as well as your retirement accounts. You should keep accumulating stock/bond investments to build up a huge nest egg for your retirement years.
The bonus? By the time you are retired, you are more than likely to have substantial brokerage and retirement accounts. You may never need to work again and have W-2 income. You would be considered wealthy. Your taxes should go down significantly, and you will have the necessary wealth to fund your desired lifestyle.
Not bad for a middle class life.
Disclaimer
This post is for entertainment purposes only. No warranty, express or implied, is offered in this posting. No client relationship is created between the author and reader. Federal and state laws vary widely when it comes to personal finance. I am not offering investment advice. You are encouraged to read more information on personal finance by different authors to gain the education you may need to manage your finances.
