There are fundamentally two ways to earn money. The first is normal income, where you get paid for your labor. The second is capital gains, where you earn money by selling assets. In either case, the Government will take a portion of your income in the form of taxes. “Income Tax” is the money the Government takes based on the money earned from your labor, and “Capital Gains Tax” is the money taken based on the profits from the sale of your assets.
Most people are familiar with “Income Tax.” In many cases, your employer will subtract the tax from your paycheck before you even see the money! And when you get a “Tax Refund” in April, the Government is actually giving some of YOUR money back to you because they took too much! If you are a contractor or run a small business, you will be able to reduce the tax that you pay by “Writing Off” some of your expenses against the money that you earn. (This is why everyone should own their own business, because you can take advantage of the same tax laws that rich people utilize to reduce their taxes!)
It is especially important to understand “Capital Gains Tax” and how investment income is used to build long term wealth! When you buy an asset, such as stocks, cryptocurrency or property, the purchase and sell price are often different from one another. When the sell price is lower than the purchase price, the loss is called a “Capital Loss” and can be used to reduce the taxes you pay. When the sell price is higher than the purchase price, the profit is called a “Capital Gain.”
Capital Gains are often taxed at a lower rate than normal income, because this encourages people to invest their money, and has an overall positive effect on a country’s economic growth and job creation. It is important to understand the reason taxes are only paid on the “Capital Gain” rather than the entire sale price of the asset. This is because the money used to purchase the asset was already taxed at the time that money was earned. On the surface it will appear that someone is only paying tax on part of the money earned from the sale of the asset, when the reality is that the Government is trying to avoid double taxation of the same income.
So how does this relate to Elon Musk paying so little in taxes… and then setting a world record for the most taxes ever paid in history by an individual? Most people, the wealthy included, don’t have a lot of money in the bank. Most of their wealth is comprised of their assets (investments, property, etc.) because money sitting in the bank isn’t very productive. Elon is no exception.
A common strategy for building wealth is to invest most of your money in starting a business, or in assets that will gain value over time. The next step is to live very modestly and reinvest any profits back into your business and other investments. This has the double benefit of improving your odds of success with your business, while also reducing the taxes that you pay. (Tax laws are generally written to benefit people who invest profits back into their business because this grows the economy and helps society as a whole and creates jobs.) These same tax laws are also designed to benefit people who invest money for their retirement, because this will reduce the burden on society when they becomes old and are no longer working.
So how did Elon Musk not pay taxes for so many years, even though he is the richest man in the world? The answer is very simple. He didn’t actually earn any money during those years. Elon’s wealth is tied up in his businesses, but he has enough money in the bank to live modestly without needing to pay himself a salary. Elon rents a small apartment (worth about $50,000) near his work, and often stays with friends that he is visiting. By keeping living expenses low and focusing on growing his business, Elon can live for many years on his savings, without needing to earn additional money or sell his assets. Remember that time when Elon sold most of his fancy homes and luxury items? He could probably live off that money for the rest of his life without needing to earn a salary from his companies. Should Elon need money, he can borrow against his assets, and maintain his focus on building his businesses. (This strategy is common among entrepreneurs, including myself).
Recently, Elon Musk sold some of his Tesla stock, and paid $11,000,000,000 in taxes (the largest tax payment from an individual in world history) due to the profits from the sale.
There are two important lessons we can learn from this:
1. Start a business and reinvest profits back into the business. This improves your odds of success with the business while also minimizing your tax payments. Entrepreneurship and investment is generally the best path to becoming successful and independently wealthy.
2. Taxes are only paid when you sell an asset. “Unrealized Gains,” or the change in value of an asset before you sell it, can be useful when borrowing money against your asset, but is otherwise meaningless. Also, you won’t actually know what an asset is worth until someone is willing to give you money for it.
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