What Warren Buffett Might Say About Taxes

Warren Buffett is known as the Greatest Stock Market Investor of the last 5 decades. In 2015, he was ranked by Forbes Magazine as the 3rd wealthiest person in the world. He is known for many wise sayings about investments; the world of money; and life.

His #1 Rule: Don’t Lose Money!

His #2 Rule: Don’t Forget Rule #1!

It’s a very unique investment philosophy that virtually no one else on Wall Street follows. It’s derived from an understanding of math. If your investments go down by 40%, you will need a total 66.667% increase just to get back to where you started.

The same mathematical result occurs, whether the loss is due to a stock market crash or income taxes. If one earns $500,000 in year one and it is taxed as ordinary income at a 40% tax rate, then there’s a $200,000 loss to taxes. One would then have $300,000 left.

In year two, one would hope for a $200,000 gain in order to get back to $500,000. However, if this $200,000 gain is again taxed at a 40% rate, there would be $80,000 of taxes and one would only have the $300,000 principal at the end of year one plus the $120,000 net-after-tax-gain, or $420,000 at the end of year two.

One would actually need to have a $333,333.33 gain in year two (a whopping 111% gain), less the 40% tax of $133,333.33 to net a $200,000 gain. Now, we would be back to $500,000 at the end of year two, which is where we started at the beginning of year one.

Buffett understands the incredible reduction in net wealth if taxes eat away your gains. As a result, he uses advanced tax planning in order to sell $billions of assets with little or no tax. In fact, he says that it’s unfair that he pays a lower rate of tax than his long-time secretary. During one year, Buffett paid a 17.4% average rate of tax, compared to the 33.0% that his secretary paid.

Buffett would love the Roth IRA conversion strategy. All tax-deferred retirement accounts, whether it is the IRA, 401(k), 403(b), or 457 plan, allow one to deduct contributions; let the earnings grow tax-deferred; and then only be taxed when distributions are taken. There is no capital gains taxation and all taxation of withdrawals is ordinary income. Example of a $100,000 Roth IRA conversion: one converts $100,000 of any tax-deferred account to a Roth IRA and this creates $100,000 of taxable income in the year of conversion. It’s not an extra tax as money in a tax-deferred retirement account is always taxed when withdrawn.

However, with the money now in a Roth IRA, there is no taxation if two rules are followed: you do not withdraw money until at least age 59.5 and you wait at least 5 years from the time your first Roth IRA was established. Now, there is NO taxation on your earnings, no matter how much you earn, for up to three generations.

You want to pay the Roth IRA conversion tax with money NOT inside the IRA, 401(k), 403(b), or 457 plan, because you want all $100,000 to enter the Holy Grail of tax planning, the Roth IRA. If you earned $1 million or $10 million inside the Roth IRA, there is NO taxation, period.

There are many advanced IRA strategies, involving the Roth and Multi-Generational IRA. If you learn them, amazing things can occur for your family.