Getting Gifts

When you get money as a gift, you’ve got nothing to report to the IRS. Gifts aren’t taxable income. So, if you can arrange it, my advice would be to receive all your money this way. In addition, this method of paying the bills will also significantly reduce the time you now spend working for a living. In my experience, however, the only people who consistently manage to receive significant portions of their income this way resemble Mae West (wink, wink). But if you do find a way to accomplish this without the Mae West approach, please forward this information to me ASAP.

Borrowing Money

Borrowing money also results in no requirement to report taxable income, because borrowed money is only yours temporarily, and is therefore not considered income for tax purposes. Despite this tax advantage, however, I would stringently advise against this method of making ends meet.

Collecting Interest

Interest income is just like your salary: totally taxable in the year it is either received or receivable. So when it comes to being able to shift your taxable interest around to try to influence the amount you’re reporting in any given year, good luck. In this respect, interest is basically like your salary; you have no control over when it’s paid. The only possible exception is the interest from a debt that’s owed to you in the form of a personal or real estate loan. Then you might be able to exert some influence on the person who owes you the interest by pleading with or coercing them to pay it in a fashion that would move the interest from one tax year to another. But by and large, your interest income isn’t much more flexible timing-wise than your salary. Unless that interest comes from a tax-advantaged source.

The main source of tax-advantaged interest we’ve already discussed: tax-free interest from various types of government bonds. You’ll recall that interest arising from state or local government bonds (i.e., municipal bonds) is normally federally tax exempt. Interest from federal obligations (i.e., treasury bonds) is exempt from state and local taxes. And the interest from bonds issued within the state where you live (i.e., local municipal bonds) is the best deal of all, because that can be completely tax-free: federal, state and local. But as you’ll also recall, the problem with these sources of tax-free interest is that the tax advantages are usually off-set by lower interest rates, so what you gain by not paying taxes on these sources of interest you lose by not getting as much interest to begin with. Since that’s not always true, however, you should periodically check the rates available on tax-free bonds and mutual funds, especially if you live in high-tax states like New York or California. And, as we just discovered in our discussion about tax brackets, you should also see what your tax bracket is. Once armed with this information, you’re ready for a quick computation. Remember the formula? Taxable rate times reciprocal of tax bracket = equivalent tax-free rate. Here’s an example:

Taxable Rate (for example, the rate available on a medium term bond fund) = 5%

Reciprocal of Tax Bracket (if I’m in a 30% tax bracket, the reciprocal is 1 minus .3) = .7%

Equivalent Tax-Free Rate (5% x .7%) = 3.5%.

Result? We’ll have to find a tax-free rate of more than 3.5% to be better off than earning 5% in a taxable investment. This will probably prove difficult to do in investments of similar risk, but it’s still worth scoping out every now and then, especially since it’s so easy to do. In fact, I’ll do it right now, time myself, and see how long it takes.