It’s likely you remember the anticipation of the very first paycheck you received from your first real job. However, when you opened the envelope containing your check, there was undoubtedly some disappointment.
I went to Catholic school, and we had nuns teaching some of the classes. Every now and then one of the nuns would express her severe disapproval with someone by issuing a whack (think ruler plus hand or eraser plus body). If someone was goofing off, they got a whack. On the other hand, if someone did something really 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.
The IRS is no different. It whacks certain types of income. For example, if you are out there working hard for wages at McDonald’s, you learn very quickly that you have all these different taxes—FUTA, SUTA, old age, death, and survivors, Medicare, withholding for federal, withholding for state. It seems like everybody gets a cut of your money before you ever see it. I saw that for myself when I worked for McDonald’s when I was younger. 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.
How is that possible? The key is understanding what the IRS will whack, and what it will pat. The short answer to a complicated question is this: not all sources of income are treated equally. Wages, profits, rents, royalties, dividends, interest, short-term capital gains, long-term capital gains—they are all treated differently. Generally speaking, you can divide these different kinds of income into three buckets: bad, better and what I call “infinity.”
In the bad bucket, wages get the biggest whack from the IRS. If you work at McDonald’s and you’re making $30,000 a year, whack, whack, whack, whack. You get hit with old age, survivors, and disability insurance at 14.1%. McDonald’s pays half; you pay half. For Medicare, McDonald’s pays half, you pay half—2.9%. You pay all of some of these as well: federal unemployment, state unemployment, worker’s comp, plus labor and industries. All of these are getting drawn out of your wages before anyone hands you a check. You also pay federal income tax withholding, and you pay state income tax withholding if your state has income taxes. This means that in a week when you make $400, you might get to keep $330, and probably less.
In the better bucket, rents, royalties, and interest are okay. With these, you 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.
The best bucket is the infinity bucket, which includes real estate. The real estate you own could grow from a dollar to $10 million, and you won’t get dinged. Meanwhile, the McDonald’s employee made $400 and paid more in taxes than the individual with real estate did, and they made 10 million bucks. That’s real estate. The IRS is telling you what to invest in.
The wealthiest Americans are 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.