What I’ve Learned From Nuns And The IRS

Tax comes from the Latin term taxare, which means to censure or express severe disapproval in something. I went to Catholic school, and we had nuns teaching some of the classes. The funny thing about nuns is that every now and then one of the nuns would express her severe disapproval with someone by issuing a whack (think ruler + hand or eraser + body). If someone was goofing off, they got a whack. On the other hand, if someone did something good in class or did some helpful public service, they got a little pat on the head and some positive reinforcement in the form of nice comments. Which would you rather have? The whack or the pat on the head?

The IRS is no different. It whacks certain types of income. For example, if you are out there working hard for wages, you learn very quickly that you have all these different taxes—FUTA, SUTA, old age, disability, and survivors, Medicare, withholding for federal, withholding for state. It seems like everybody gets a cut of your money before you ever see it.

When I was growing up, I worked at McDonald’s and made close to four dollars per hour at the time. If I worked forty hours, I assumed I would receive $160 on my check. Guess what? When I received my paycheck, it was far less because of tax withholding, workmen’s compensation, Social Security taxes, and a variety of other fees and taxes I did not understand. I felt like I had just received a “whack” when I saw all of that money leave my paycheck. Chances are you are getting a bunch of whacks from the IRS.

By comparison, let’s look at the rich. They sell some real estate for hundreds of thousands more than they paid for it and they don’t even have to pay tax on it because they rolled it into more real estate. They sell that at a profit and buy even more and, you guessed it, no tax. When they pass away, not only is there no tax, but their heirs will receive massive tax write-offs. They don’t get a whack; they get a pat on the head from the IRS.

You just have to decide: do you want to keep getting whacked or would you like an occasional pat on the head instead? Well, there are plenty of ways to get the pat instead of the whack.

We could just look at the wealthiest people to see what they are doing. They’re not over here getting whacked all the time on their income. In fact, only a small fraction of their income is getting whacked. The majority of their income is from the sources where they’re getting the little pat on the head from the IRS.

The IRS doesn’t view all income sources the same way which is critical to creating a successful financial future. In our system these three income sources fall into three buckets:

• Bad Bucket: Wages get the biggest whack from the IRS. The other giant whack from the IRS perspective is self-employ­ment income. If you’re working for yourself as a sole proprietor, the whacks start. First, you’re going to get audited more. Second, you’re not going to get all the write-offs you’re entitled to. Third, you can’t do an accountable plan because you are a tax disadvantage from a tax standpoint. And fourth, every dollar that you make is subject to self-employment taxes. It’s a complete whack-a-thon.
• Better Bucket: By comparison, rents, royalties, and interest are okay. With these, you generally don’t pay any Social Security taxes or Medicare. Royalties, interest, and short-term capital gains are taxed at your ordinary bracket, though. So while they’re okay, they’re not great. You’re still paying on them at your tax bracket. You avoided a big chunk of tax, but you still have some tax, and it’s not the greatest tax rate.
• Infinity Bucket: The best income source is real estate. I may never pay tax on real estate, and neither will my family. I could own real estate and it could grow from a dollar to $10 million, and I will have paid nothing in tax. Second best is qualified dividends and long-term capital gains – where the rate could be $0 depending on your income, but are capped at about half of what ordinary rates are even if you are making a ton of money.

It is up for you to decide: Do you want whacks on the knuckles or pats on the head? Maybe some whacks are inevitable as you learn and grow, but the goal is to get the IRS pats the rich enjoy.