Don’t tax you, don’t tax me, tax that fellow behind that tree”.
–Senator Russel Long
“The best way to teach your kids about taxes is by eating 30% of their ice cream.”
–Bill Murray
Some of the highest real tax rates apply to middle and upper-middle-income taxpayers, not people who make a lot more money.
And some billionaires in the US have paid no taxes at all in recent years. Eighteen were eligible for coronavirus stimulus checks.
I am not making this up.
I wouldn’t say I like that fact. But that is not the point of this post. The real issue is how MMH readers can use the same kind of themes and strategies that the very wealthy use to build wealth and also keep their taxes to a legal minimum.
So, we will look at the issue. To do that, first, please understand that the rich have far more tools in their toolbox and a lot more resources to deal with tax issues. Moreover, they tend to be concerned about taxes because they can be by far the biggest expenditure in their budget, unlike most of us.
However, some financial principles apply across the board, regardless of your net worth, income or tax status. And we will discuss what strategies apply to everyone. Please understand, I am talking about the relationship between taxes and wealth. I am NOT a tax expert. If you have tax questions, speak to a professional.
THE WAY IT THE SYSTEM IS SUPPOSED TO WORK
In theory, the current taxation system for salaries and bank accounts should be equitable because we pay a progressive tax. That means that people who make less income pay a lower percentage of income in taxes, and people who make more pay a higher percentage.
For instance, if you are single and make $518,401 per year, the last dollar you earned was taxed in 2020-2021 at a 35% rate by the Federal Government. Or if you make more than that, you paid 37% on the last dollar you made.
And that is fair. You make more; you pay more. You make less; you pay less.
After all, while paying taxes is a fact of life, it is hard to garner sympathy for people who make more than $518,401 per year. They should pay more in taxes. They can afford it. And theoretically, billionaires pay the highest rates under this system. After all, they make far more than $518,401 per year.
SOME BILLIONAIRES DON’T PAY TAXES
It turns out that it is not that simple.
According to ProPublica, many of the wealthiest people in the country have paid no income tax in some recent tax years. You can read about that here.
The non-taxpayers are a pretty diverse and wealthy group, including George Soros, Warren Buffett, and Carl Icahn.
And it turns out that many of the wealthiest politicians of both parties don’t pay much either…
I know, I know, try to hide your surprise. But, in a politically fractured country, it turns out that one cause helps unite the right and left: pay the least in taxes you can legally afford.
Let’s take a more in-depth look at some of the most important things to know.
POINT 1: STRAIGHTFORWARD DOCUMENTED CASH TRANSACTIONS OFTEN CARRY THE HIGHEST TAX RATES
These include the most basic bread and butter types of income: salaries and interest paid to you from savings. These sources are straightforward and involve an exchange of income for money or interest income for the use of money. And they are easy for financial institutions to track and report to the IRS.
Most people depend on a salary. And depending on how high their pay is, it can also mean they pay some of the highest tax rates.
Impacts for most people
High tax rates for salaried income go with the territory. This is because most people have bills to pay and use their wages to do that. Depending on the state you live in, the combined Federal and State rates can be 50 percent if you make a lot of money.
What the wealthy do
They do not take much in salaries and so avoid paying taxes.
POINT 2: IT IS ONLY TAXABLE IF YOU SELL IT
According to long-established legal precedent, it is a sale that causes a taxable event. This is because you are taxed on the difference between what you bought something for, and the sale amount. So, while your salary or interest from your bank account is taxed, an unrealized sale is not. It is only taxed when you sell.
Impacts for most people
People buy and sell things all the time. For example, if you have an old car, you usually sell it when you get a new one. Or, if you have a house, the same principle applies. Uncle Sam usually gives you a break on these kinds of transactions because there is not a lot of money involved.
What the wealthy do
On the other hand, the wealthy usually own many things–stocks, homes, real estate, etc. They typically don’t sell them. Instead, the very richest borrow against their assets and live off the loans. There is an explanation as to how that works here.
POINT 3: IF A BUSINESS TRANSACTION/INVESTMENT IS “RISKY, ” SOMETIMES IT IS TAXED LESS. WHEN YOU WIN, YOU ARE TAXED LESS, AND WHEN YOU LOSE, YOU CAN WRITE OFF LOSSES
Impacts for most people
If you have little money, you are usually not engaging in much investment. And you probably are not running a business and taking on business risk. So, these types of tax breaks likely don’t apply to you.
What the wealthy do
They take advantage of these rules by investing instead of spending. And sometimes a sale hurts a little less tax-wise when you are talking about investments. Long-term capital gains rates are at most twenty percent. The same tax rates apply to dividends paid by companies. Both are less than the top income tax rates, so income for wealthy individuals often comes from those two sources.
POINT 4: CHARITY IS DEDUCTIBLE–ESPECIALLY FOR THE RICH
Charity is tax-deductible. However, to reduce what people pay in taxes, a donation must be large enough and be coupled with other large deductions to make a difference. The standard deduction is over $12,000 per person, while the average American family donates about $6,000 per year.
Impacts for most people
For many lower-income taxpayers, their charity and deductible expenses don’t exceed the standard deduction. So, there is no impact on their taxes.
What the wealthy do
Instead of paying taxes, many make sizable contributions to charities—often ones that they set up. Or, they help fund those charities which concentrate on issues that they feel are important. To see some of the trade-offs and get a better idea of how this works, see here. The article references a $30 billion decision—to give to charity or pay taxes.
POINT 5: THE INHERITANCE TAX DOES NOT AFFECT MOST PEOPLE–BUT DOES NOT AFFECT THE WEALTHY MUCH EITHER
You might think that, upon death, the taxman finally gets even with the wealthy. After all, you can only exclude $11.7 million from inheritance taxes. And for billionaires, that is a tiny fraction of their net worth.
Impacts for most people
For most of us, inheritance taxes are not much of an issue. The top one percent levels of net worth are slightly less than the $11.7 million exclusion. So, inheritance taxes impact those who are over the top one percent in net worth. The rest of us are safe.
What the wealthy do
There is a cottage industry that revolves around legally avoiding inheritance taxes. These involve setting up complex trusts for wealthy families. To read about that, see here.
POINT 6: IF YOU OWN A BUSINESS, THERE ARE TAX ADVANTAGES
Impacts for most people
Most people do not own a business. There are significant risks; businesses require tremendous sacrifice and work. Moreover, not everyone either wants or can run their own business.
What the wealthy do
Most own businesses or invest in them. To see why that matters and find out about some of the tax consequences, see here.
POINT 7: THEY TAKE THEIR LEGAL DEDUCTIONS
Impacts for most people
Taxes for most middle-income families are relatively small. Tax costs are usually dwarfed by more basic expenses like housing, food, and transportation. See the recent post about those costs here. That is why many families are best served by looking at their major expenses first before worrying about taxes.
However, there also are a lot of deductions that can be taken that help toward housing, retirement, and other important issues. These can include investing in retirement accounts, real estate, and a host of other measures that have favorable tax consequences and can help you plan for the future.
What the wealthy do
They hire experts to help them, and they oversee their tax expenses. The wealthy spend so much time on tax issues because the combined state and federal tax bite can affect HALF of what they earn.
SO, WHAT ABOUT THE REST OF US? WHAT CAN WE LEARN FROM THE WEALTHY?
It is crucial NOT to obsess on taxes but consider them as just another expense.
But there are some valuable lessons about what the rich do. So if you want to achieve that financial status, it is vital to note these common-sense themes that they use. They:
- own things. They don’t rent them (businesses and real estate are primary ownership choices).
- become wealthy by appreciation–they take a relatively small amount of money and make it far more valuable over time, often by investing or by starting a business
- don’t sell their assets and take gains
- take calculated risks
- try to defer taxes and use the legal deductions available to them
CONCLUSION
Those actions are reasonable for anyone, not just the well-to-do. If you can, use the same strategies and legal tax strategies that are open to you.
Disclaimer: consult with a financial professional before taking any steps outlined here. Not all advice is suitable for your circumstances or investment style.
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