How the rich get richer by minimising taxes and leveraging debt
Ever wonder how the super-rich seem to have plenty of cash to splash, but they only have to pay a minimal amount of income tax?
Well, there’s a trick to it – but you don’t have to be a Jeff Bezos-level billionaire to master it. Here’s what you need to know to start funding your personal lifestyle by minimising taxes and leveraging debt.
In this article:
- Mo’ money, mo’ problems
- The taxes of taking money from your business
- Borrowing against income-producing assets
Mo’ money, mo’ problems
My wife Liz and I recently started bingeing a new Netflix series called Manifest.
It’s about a group of passengers onboard a flight from Jamaica to New York. They run into a bit of turbulence mid-flight and arrive at their destination… years later. To the passengers, the flight was only a few hours long. The actual time passed was five years.
After finishing the first episode, Liz and I started pondering. What was our life like five years ago?
We paused for a moment and concluded – it was pretty boring!
Our lifestyle back then was markedly different. Not by choice, mind you. Liz was grinding in a Big Four accounting firm. I was grinding trying to get SBO Financial off the ground.
As a startup business owner, all effort and attention was directed to surviving. Financially speaking, I didn’t pay myself for 18 months. I had to keep my personal burn rate minimal to make the runway of personal savings last as long as possible. Every spare dollar was reinvested into the business.
Fast forward five years, and fortunately we’re in a different position. We have a profitable, stable business and I’m taking a somewhat decent salary.
|I was working 70+ hours a week out of necessity||Still working many hours, but by choice|
|Anxiety / stress was quite high||Still get stressed / anxious, but not all the time|
|Didn’t own a car||Own a car|
|Childless||Have a child|
|Living expenses low (less than $2k a month)||Living expenses moderate ($3-5k per month)|
But as my income has grown, so have my expenses. We’ve entered the next phase of life. On the horizon are childcare fees, school fees, a second car, more mouths to feed. As such, personal income drawn from the business will soon need to increase.
My business partner and I are in a fortunate position to be able to afford to increase our take-home pay, but our personal preference is that we don’t. This is because our capital is better re-invested into compounding business and investments – the financial opportunity cost is high for every dollar that is withdrawn from the business and isn’t re-invested to generate returns.
The taxes of taking money from your business
Business owners pay a “tax” on every dollar that’s withdrawn from their company bank account. The tax paid is:
- Income tax (the amount the federal government takes from you on dividends / wage)
- Opportunity cost tax – a “tax” on the lost opportunity of reinvesting that same dollar into growing your business and generating returns.
Most folks understand the income tax cost, but few truly understand the opportunity cost – because it isn’t a ‘tax’ per se. But it is a real expense that needs to be considered.
Let’s take the example of an entrepreneur who owns and operates a business doing $150,000 per annum of EBITDA (earnings before interest, taxes, depreciation and amortisation). On an annual basis, the entrepreneur has two choices:
- Pay an annual dividend to himself (in addition to his market salary); or
- Re-invest the $150k into the business and continue to compound it at, say, 15 per cent per year by growing it.
Calculating the future value of a fixed return of 15 per cent in the business over a 20 year period reveals that, by not withdrawing the $150,000 per year, the entrepreneur will forgo $17.82 million in favour of $3 million.
The opportunity cost of withdrawing the $150,000 per year is $14.82 million in future value.
And this doesn’t even take into account the taxes that the entrepreneur will pay on the dividends on the way out – in reality, the $150,000 dividend is more likely to be around $100,000 cash after income tax.
When you frame it like this, you can start to understand the power of capital compounding in your business, and why it matters. A lot.
It’s this kind of thinking that makes my business partner and I hesitant to draw excessive amounts of capital from our business, because opportunity cost is significant.
But that doesn’t change the fact that we still need money in our personal lives to provide for the household. So the question is – how do we have both?
Borrowing against income-producing assets
How can we ensure that we can reinvest as much money as possible into capital compounding investments, while still having enough money in our personal life to live?
Enter Jeff Bezos.
Jeff Bezos is the world’s richest person. His net worth is estimated to be $178 billion.
Accordingly, he lives a pretty baller lifestyle. For example, he owns a $485 million super yacht. It’s so big the city of Rotterdam in Holland had to remove a section of a historical bridge just so it could fit.
Despite amassing this fortune, Bezos paid no federal income tax in 2007 and 2011. You read that right – you probably paid more income tax than Jeff Bezos in those years. So how is it that Bezos is a billionaire, but on a relative scale pays less tax than you or I?
He does it by using debt.
Prudent financial planners and gurus preach that debt is bad. You want as little of it as possible.
Personally, I teeter on the fence on this. I don’t like debt – but if used wisely, it can make you rich, because debt gives you leverage.
I’m going to show you an example of how a business owner or investor can think about using debt to create wealth. I’ll be using my own situation as an example.
This diagram shows my current investment structure.
The majority of my investments are in private businesses and illiquid assets (assets that cannot be quickly converted into cash), owned by our holding company Arbor Group. Outside of the company, we own our home and a small parcel of equities in index funds.
Now, let’s say I needed $100,000 in cash within the next six months. What the cash is for doesn’t really matter, but let’s assume I need the money for ‘life stuff’ – private school fees and a second car.
OK, so how do I get this $100,000 in cash in my hands?
Assuming you have a cash flow producing business that has retained profits and surplus cash, you can pay a dividend from your company. You withdraw this money from your company bank account and deposit it into your personal one.
The problem is, to have $100,000 of cash in your personal hands, you will need to transfer more than $100,000, because of taxes.
Assuming you’re on the highest income tax bracket in Australia, the after-tax cash result of a $100,000 dividend is more like $73,000. So for you to personally receive $100,000 in cash after personal taxes, you actually need to withdraw $140,000 in cash from your company.
So that’s the income tax paid on taking money from your business via a dividend.
Now let’s talk about the opportunity cost of that dividend.
The $140,000 that I’ve withdrawn from my company has an opportunity cost. If, instead of withdrawing money, I reinvested that $140,000 into my business and investment opportunities at the target 20 per cent IRR (internal rate of return) – over a 20 year period, that $140,000 would actually be worth a whopping $5.37 million in future value.
The opportunity cost ‘tax’ I pay on having $100,000 now is $5.27 million in 20 years time ($5.37 million, less $100,000).
I’ve learned that the common trait of financially successful people is that they always think in opportunity cost. If you want to be rich, you should too.
So, now we understand that taking money from our investments has a cost. But that doesn’t solve the problem of needing that $100,000 now. I need liquidity, baby!
So here’s the second strategy that allows you to access that $100,000 now, and keep that $140,000 in your business to continue its capital compounding journey.
We use debt.
My home currently has $500,000 of equity in it. This is equity that the bank will allow me to borrow against. I can refinance my home loan to access $100,000 of cash, assuming it fits the bank’s LVR (loan-to-value ratio) requirements, which it does.
The net effect is that my home loan equity reduces to $400,000, and I get access to the $100,000 I need.
The advantages of this strategy are two-fold:
- I don’t pay any tax on this $100,000.
- The $140,000 that I would otherwise have paid from my company continues its journey and (hopefully) turns into $5.37 million in 20 years’ time.
Now, I know what you’re thinking: “Jason, what about the interest expense on that $100,000 that you’ve just refinanced?”
Yes, it’s true; that is a cost we need to consider. Assuming an interest rate of 3 per cent per annum on a home loan, it will cost me $3,000 per annum to have access to that $100,000.
But consider this – I’m creating $28,000 of wealth per annum by investing the $140,000 in the business at a 20 per cent return ($140,000 x 20 per cent = $28,000). So I’m net better off.
And besides, if I struggle to service an extra $3,000 of interest every year, I can always pay a dividend from the company to cover it, so I’m still better off. By a longshot.
This is the exact strategy used by the rich. It’s how Bezos didn’t pay any income tax in 2007 and 2011. It’s how most, if not all, asset-rich and cash-poor billionaires structure their finances.
To fund their personal lifestyles, they borrow against income-producing assets.
They wisely utilise debt, allowing them to have their cake and eat it too.
Disclaimer: I am not a financial advisor and this is not financial advice. This article constitutes my personal views only and is primarily for entertainment purposes. It is not to be construed as financial advice in any shape or form. Please do your own research and seek personal advice from a qualified financial advisor.
Also, for the record, I am not against people paying taxes – in fact, I love it. It means I’m making money.
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