It does not matter how much your employer pays you. It is all about what you keep.
One thing that I have noticed about self-employed people is that they think about their earnings in terms of post-tax income. Employed people tend to think about their pre-tax income. This is why I think so many employed people are likely to spend more than they earn, and self-employed people tend to be careful savers.
Pre-tax vs. Post-tax Income
People who do not make a lot of money earn roughly the same amount in post-tax dollars as pre-tax dollars. As you go up the income scale, this shifts. Wealthy people earn far more in pre-tax dollars than post-tax dollars. If you pay an effective tax rate of 33%, then your pre-tax income is 50% larger than your post-tax income.
This mathematical difference is lost on a lot of people. While it takes a 33% tax loss to make $1,000,000 equal to $666,667, it takes a 50% jump to get back to the $1,000,000 starting point. Hence why it is so important that people use whatever tax shelters they have.
Just think about the tax shelters you can use:
- Mortgage interest – Paying interest on a mortgage is not at all a big deal. First, homes generally go up in value. Second, you will have to pay rent anyway, so the payment does not go away if you do not buy a home. Finally, you can shelter your income from interest on up to $1.1 million worth of mortgages plus lines of credit on your primary residence.
- Retirement accounts – 401Ks and IRAs can be funded with pre-tax dollars. If your current tax rate is higher than your tax rate at withdrawal, you come out as a winner. Most people fit into this scenario because they save most of their income during their highest earning years, which are often right before retirement. Your income in your 40s and 50s is probably as high as it will ever be, and taxed at a rate that you won’t reach in retirement. Therefore, dedicate as much pre-tax income as you can to retirement accounts.
- Businesses – Businesses make for great tax shelters. If you own a business – either on the side, or full time – you can deduct a lot of things that you cannot deduct as an individual.
- Trusts – This is a complicated topic which I want to cover in-depth in the future, but trusts can be excellent for shielding against taxes, especially estate taxes. You do have to be very wealthy to use this shelter and get the full benefit, but trusts can save you a lot of money at tax time – and avoid countless large taxes like the estate tax.