Ordinary Income. Extraordinary taxes.

 

Manna wasn’t legal tender, but that doesn’t mean the IRS wouldn’t have tallied it.

 

A couple of days ago we pointed out how money doesn’t care where it came from. Some people think that their regular salaries should go towards daily expenses, while windfalls (inheritances, stock appreciation, house appreciation, etc.) can go towards less vital stuff like vacations and ATVs.

That’s an idiotic perception. If you have an asset to buy, defining “asset” as we do here at CYC (something that’ll build wealth), buy it. With your paycheck, or with a handout from Grandma. Or even a loan from Grandma, depending on what interest she charges. Otherwise, it shouldn’t matter. Regardless of its origins, money goes where it goes.

Well, that’s not entirely true. The only entity that cares how you came by your money is the Internal Revenue Service. Receive money one way, it’s taxed at a certain rate. Receive it another way, it’s taxed at a higher rate. Seeing as the IRS has the power of deadly force*, soon for the crime of not doing your duty for the Motherland and buying health insurance, it makes sense for us peons to accede to the agency’s capricious demands.

As far as the IRS is concerned, there are 2 ways you can receive income:

  1. ordinary income and short-term capital gains
  2. long-term capital gains.

This is simplified, obviously. A full accounting of every exception would take us years to write about.

Ordinary income? That’s:

  • Wages, salaries, tips, commissions, bonuses
  • Interest, dividends, and net income from a business that you own a piece of
  • Gambling winnings
  • Royalties
  • Rents
  • Pensions, assuming you’re one of the few people who collects one.

Meanwhile, capital gains are:

  • Money from the sale of a “capital asset”, like shares of a publicly traded company, or a house that you sold. Unless you’re a land developer and the house is your stock in trade, that kind of thing. The difference between short- and long-term capital gains is arbitrary but defined: hold on to an asset for a year before selling, that’s long-term.

We’ll spare you the numbers, but regardless of what tax bracket you’re in, long-term capital gains are always taxed at a lower rate than short-term capital gains and ordinary income are. There’s a good reason for this, too. Ordinary income (and to a lesser extent, short-term capital gains) carries little risk. If you punch a clock, you’re legally entitled to wages and can sue if you don’t receive them. If you wait tables, society expects that customers will tip you as part of (if not the bulk of) your income.

Long-term capital gains involve tons of risk. There’s no guarantee that that stock you bought years ago might ever result in a payoff. Contrast that with the biweekly checks you get after entering into a standard work agreement. By taxing long-term capital gains at a lower rate than ordinary income (and short-term capital gains), the IRS encourages people to hold onto their investments. If all income was taxed at the same rate, there’d be no incentive for anyone to defer spending (synonyms for which are “save”, “invest”, and “build wealth”.) We’d only chop trees down, never planting any.

So is this just an accounting curiosity, something for you to pass the time reading about on a boring Wednesday? Heck and no. Control Your Cash don’t play that game. If it didn’t apply to your life, we wouldn’t be spending time on it.

The more of your income you can derive via long-term capital gains, the less you’ll have to fork over to the IRS. We devote an entire chapter of the book to this. Chapter IX, the longest and most detailed one. (By far. Although it’s still easy to read, certainly no more difficult than our posts.)

Unless you want to move to Antigua – and before you do, remember that it’s easy to go stir-crazy on a 109-square mile island – you’re going to have to play the IRS’s arbitrary game. Both Wonderland croquet and Calvinball have more consistent rules. This wasn’t always the way, but America’s descent from beacon of freedom to patchwork of statism is a topic for another day.

Maximizing your long-term capital gains is the inevitable result of buying assets and selling liabilities, our 2-pronged guaranteed way to wealth. It means purchasing vehicles for passive, non-sweat income, no matter how modest or expensive: a $25 mutual fund contribution here, a real estate investment trust there. Anything that creates an income stream for you, or that should appreciate (such as a house). Hold onto it for at least a year, and you’ll pay less in taxes that you would if you’d earned similar income via more direct means. Hold onto it indefinitely, and…

You can defer capital gains, too. Sometimes indefinitely. Methods for doing this include structured sales, charitable trusts and 1031 exchanges, which we touch on in the book and will expand upon in future posts. Really we will.

The point is, don’t go to H&R Block with your W-2s and say, “Fix this for me.” And really don’t get a refund anticipation loan. You’ve got a few months to make this work for 2012, and to figure out how to not get burned in future years. Do it now. (By “do” we mean “buy”, and by “it” we mean click the link above. Which is also this link.)

 

*This is not an exaggeration. To quote P.J. O’Rourke, “If you don’t pay your taxes, you get fined. If you don’t pay the fine, you get thrown in prison. If you try to escape from prison, they shoot you.”

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