Three Ways to Legally Avoid Paying Income Taxes

How to Avoid Paying Income Taxes:

Unless you are Donald Trump and you are carrying forward hundreds of millions of dollars in losses from previous years, chances are you will not be able to avoid paying income taxes for a few decades. No need to fret, losing hundreds of millions of dollars isn’t the only way to avoid paying taxes during your lifetime. Below are three ways for residents of the United States and Canada to conceivably avoid paying any income tax for many years on end.

 

Method 1: Invest in Tax-Advantaged Retirement Savings Plans

The government is more than happy to let you off the hook from paying some of your income taxes if it knows you are saving for your retirement. Why wouldn’t it? The government doesn’t want a whole population of seniors running around with no money saved up to take care of themselves. It is for this very reason that retirement plans such as 401ks and Roth IRAs exist in the US and that retirement plans such as RRSPs and TFSA exist in Canada. The government wants you to take advantage of these plans.

Its hard to think of a better way to avoid paying taxes than by investing in tax advantaged retirement savings plans. Take a Roth IRA for example. With a Roth IRA you pay taxes up front, but then all your contributions get to grow and compound tax free. Furthermore, your withdrawals from the Roth IRA in your later years are also tax free.

Canadians receive a similar benefit with TFSAs. A TFSA gets taxed on the initial contributions, gets to grow tax free, and then owners get to make all their withdrawals tax free. With a TFSA Canadians get the advantage of being able to make tax free withdrawals at any age and, furthermore, withdrawals don’t count towards income when the Canadian government decides if you are eligible for the old age supplement.

Consider the following example. If a couple were to religiously invest $5,500 each into a Roth IRA every year and were to realize an annual return of 7% each year, then that couple will have amassed total savings of roughly $1 million after 30 years. If this couple were to continue to earn a 7% return on their savings, then they would now earn $70,000 a year tax free.

It’s not hard to see how a couple that has amassed enough savings in a Roth IRA could conceivably retire, live off of their savings, and pay virtually no income tax for many years.

 

Method 2: Make Investments That Get Taxed Favourably

Generally speaking, you get taxed on three different types of investment income. These types of investment income are: (1) interest income, (2) dividend income, and (3) capital gains.

Interest income is usually earned on fixed income types of investments such as bonds and savings accounts. For the most part, interest income gets taxed at the same rate that ordinary employment income gets taxed at.  Municipal bonds in the US are an exception to this rule as they are typically free from US federal income taxes.

Dividend income is the income investors often receive when they purchase the shares of companies listed on stock exchanges. Unlike employment income and interest income, dividend income can often get taxed much more favourably than the rate you get taxed in your marginal tax bracket. In the US, qualified dividends enjoy tax rates ranging from 0% to 23.8%. In fact, for the 2016 tax year, an individual would be able to earn up to $37,650 and a couple up to $75,300 in qualified dividends and pay no federal income tax at all, assuming this was the only income earned.

In Canada, it is possible for the residents of many Canadian provinces to earn up to $40,000 in Canadian dividends (or $80,000 per couple) and pay virtually no income tax at all, again assuming this was the only income declared and that the dividends were eligible for the Canadian dividend tax credit.

This means if you are able to live a little more frugally and start using some of your hard earned money to purchase the shares of some large, financially stable companies that have a history of paying out increasing dividends, it might be possible for you to eventually live off this stream of dividend income and never pay taxes again.

The other type of investment income that typically gets taxed less than regular employment income is capital gains. A capital gain arises when an investor sells investments such as stocks, bonds, or real estate, for a profit. In contrast, a capital loss arises when an investor sells these investments at a loss.

In the US, there are two types of capital gains: (1) short-term capital gains and (2) long-term capital gains. Short-term capital gains result from profits generated on the sale of assets held for a year or less. Short-term capital gains do not benefit from any special tax rate – they get taxed at the same rate as your ordinary income. In contrast, long-term capital gains are the result of profits generated from the sale of assets held for longer than one year. Unlike short-term capital gains, long-term capital gains do get taxed more favourably and, just like qualified dividends, one is able to earn up to $37,650 in long-term capital gains (or a couple up to $75,300 in long-term capital gains) and pay virtually no federal income tax (assuming this was the only income declared). A guide to long-term versus short-term capital gains can be found by clicking here.

In Canada, Canadian residents pay income taxes on only one-half (50%) of the capital gain realized on any given sale. This generally means that capital gains get taxed at approximately one-half the marginal tax rate that Canadian residents get charged on their ordinary employment income. Canadian tax payers do not need to differentiate between short-term and long-term capital gains. All capital gains get taxed in the same manner.

 

Method 3: Move to a Country That Doesn’t Charge Income Tax.

While it might take many years to generate a tax-free income that you can live off of by following the first two methods, this third method might allow you to stop paying income taxes right now.  However, this one will definitely be more disruptive than the previous two methods, and unless you have a second passport and a way to earn income from anywhere, it will very likely be more difficult to make happen.

Nonetheless, if you don’t mind renouncing your US citizenship (something that should obviously not be taken lightly) or claiming non-resident status in Canada, and you have the ability to pull it off, then a move to a country that doesn’t charge income taxes could potentially add up to a great deal of tax savings over your lifetime. Renowned stock investor Sir John Templeton famously renounced his U.S. citizenship in 1968 and moved to the Bahamas where citizens don’t pay investment or income taxes. And IKEA founder, Ingvar Kamprad, didn’t want to pay the high income taxes in his native Sweden so he moved to Switzerland and spent 40 years there building his empire.

Before you rush over to the nearest embassy or consulate to renounce your US citizenship, keep in mind that you might be on the hook for a sizable exit tax should you chose to give up your citizenship. Also keep in mind that the estate tax that you will face on your US held assets as a non US citizen could be substantially more. This is because a US citizen can shield up to $5.45 million of property from the estate tax (2016) while a non US citizen can only shield $60,000 in US property (2016). The following article from CNBC lists all the hidden tax costs involved in renouncing US citizenship – Exposing the hidden tax costs of renouncing US citizenship.

Assuming you still want to leave the US to avoid paying taxes, here’s a list of possible countries from Investopedia that you could move to and pay no income tax in. Of course, it’s not just a matter of renouncing your US citizenship. There’s also the matter of obtaining citizenship in the country of your choice.

Canadian citizens are more fortunate in that they are able to take up residence in another country and not be on the hook for continuing to pay taxes in Canada. Canadian resident would still need to claim non-resident status – they just wouldn’t need to renounce their citizenship in order to stop paying taxes in Canada.

 

Honourable Mention: The Home Sale Exclusion / The Principal Residence Exemption.

One of the more generous tax breaks available to homeowners in both the US and Canada is the ability to realize big tax savings on the capital gains that could be generated upon the sale of a principal residence.

In the US,  residents are eligible for up to $250,000 per person or $500,000 per couple in tax free capital gains upon the sale of their primary residence (assuming the property is their principal residence and they have lived in it for two of the five years preceding the sale).

In Canada, all the capital gains realized from the sale of a principal residence are considered tax free (assuming the property was your principal residence for every year that you owned it).

This means that if you live in a home that has dramatically increased in value and you are willing to downsize,  you could have a sizeable amount of tax free capital gains available to you that could conceivably be used to purchase investments that generate a large stream of income that pays either reduced taxes or no tax at all.

Consider the following example. I currently live just outside Vancouver in British Columbia, Canada. In the ten years since I have bought my house, it has increased in value from about $420,000 to over $1 million. This means that if I wanted to sell my house and either downsize or move out to a more rural area (or cheaper part of the country) and perhaps buy a primary residence for $300,000, I would realize $700,000 in tax free money. If I then invested this tax free money in the shares of some large blue chip Canadian companies such as BCE, Telus, Royal Bank, Bank of Nova Scotia, Trans Canada…etc. I would average a dividend yield of roughly 4.2%. This means I could conceivably generate an annual income of close to $30,000 that was all tax free (assuming I had no other income). Even if I did have other income, these dividends would still get taxed far less than my ordinary employment income.

Even if I hadn’t saved anything for my whole life (and therefore couldn’t make use of methods 1 or 2 listed above) I might still be able to generate a significant stream of tax free income if I was willing to downsize into a smaller home. I’d also be able to achieve this feat without having to move to a far away country or worry about renouncing any type of resident status or citizenship!

 

2 Comments

  1. Great,

    great read. I thoroughly enjoyed reading about . Love this post!!
    It’s so interesting to see the statistics of a lifestyle we are trying to make work for us.It sounds as
    if you have worked yourself to where you want to be . Congratulations and continued good fortune!

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