Warren Buffett, 11%
John Kerry, 13%
Mitt Romney, 14%
What do these people have in common? They make money by the boatload, own cars worth more than your 401k, and yet, seem to pay far less in taxes than the tax tables would imply they should be. Those percentages are their “effective tax rates,” the amount they pay in taxes as a percentage of their total annual income. Given that they were in the highest bracket (35% from 2003 – 2012) and are only paying that little, it certainly seems like the rich are able to manipulate the tax system in their favor. Are they really?
Tax Rates: The Myth Versus Reality
Let’s start by taking a look at Mitt Romney’s 2010 tax return.
In 2010 he made $0 from wages, which are (or aren’t, in this case) taxed at normal tax bracket rates. Of course, Mitt Romney is no plumber or barista, he’s a retired investor. Most of his earnings ($12.6MM) are from capital gains (taxed at only 15% in 2012), with some interest and business income thrown in there as well. All told, he had an effective tax rate of about 14%. Seems even lower than what you’re paying, doesn’t it?
It shouldn’t. In reality, the average American doesn’t pay all that much in taxes. We have a progressive tax system in which the tax bracket rate increases with income. Most of us fall into the 10%, 15%, or 25% brackets, but those aren’t the rates we pay on all of our income – just on the highest-taxed bit of it. Here’s a visual explanation of how your income is actually taxed:
The concept of “effective tax rates” comes into play to measure the tax rate that you actually end up paying.
Let’s see an example that most folks can relate to. Let’s say you’re married with 2 kids and earn $100,000, which puts you in the 25% tax bracket. Without any extravagant tax planning, you could actually end up paying only $8,083 in federal taxes. That’s an effective tax rate of 8%, only a third of the “marginal” (or tax table) rate. Dollar for dollar, Mitt Romney pays almost twice as much federal tax as this taxpayer.
The reality is that the tax system, while flawed in many regards, is actually more progressive than it may seem. That doesn’t mean that the rich don’t take advantage of a complex tax code in ways regular taxpayers cannot.
Actual Effective Tax Rates
A couple years ago an Atlantic editor compiled IRS data to show what the actual effective tax rate is for taxpayers across income (AGI) bands:
Interestingly, for all but the highest earners, the data isn’t nearly as dire as you might expect: the tax system proves more progressive than you might otherwise be led to believe.
Nevertheless, this data demonstrates that the super-rich are somehow getting a tax break that their “merely rich” brethren aren’t, and once again focuses attention on Buffet, Kerry, and Romney: those 11%, 13%, and 14% effective rates. Those are an awful lot lower than the averages from the Atlantic’s data.
So how do (multi-)millionaires pay less taxes?
A Rigged System
We’ve actually always had a progressive tax bracket system, but over the years we added more and more deductions and “loopholes” that, while often justified for one noble cause or another, often end up giving the most help to the rich. In the 1980’s, under President Reagan, there was an effort to “simplify” the tax code. These efforts resulted in two major tax reforms that cut the top tax rates from 70% to 28%, along with some other changes.
Reagan’s tax reform laws were supposed to lower tax rates while being revenue-neutral by getting rid of most deductions and loopholes. Everyone was supposed to end up paying more or less the same amount as they did before the changes- that’s not how it worked out. Many deductions and loopholes are still there and the government collects billions of dollars less than it would have under the prior scheme.
That’s not necessarily all bad. Most economists will tell you that lowering tax rates will help fuel a growing economy. Lower tax rates should spur investment, and the benefits of the resulting economic activity should “trickle down” to the masses. “A rising tide lifts all boats,” as John F. Kennedy once said. President Reagan sold his tax policies to the American public on those same grounds: Lower tax rates, in particular for the highest earners, will benefit the entire American economy.
While some of the tax-saving tricks of the rich are out of reach of everyday Americans, it’s helpful to understand what they are.
Paying taxes like the rich
Note: while there are many tax breaks relevant to the middle class (the mortgage interest deduction, student loan interest deductions, and retirement account deductions, among others), we will not delve into them in detail in this post.
“Money that makes money is taxed at 15%, but money from hard work and long hours is taxed at 35%” – Joe Roberts, PwC
Income from wages is taxed under the normal tax bracket rates which now max out at 39.6%, but income from investments has its own lower rate schedule, topping out at 20%. The most basic play in the tax planning book is to shift your income from wages to investments, cutting the tax bill to the individual in half.
The IRS only gives preferential treatment to stocks that you hold for at least 1 year. If you sell the stock after a year, your gains will be taxed at a lower rate than your tax bracket rate (e.g. if you’re in the 25% tax bracket, you’ll only pay 15% on the gains from the stock sale). Similarly, dividends that you hold 60 days before and after the date a dividend is declared will be taxed at only 15%. There are some complex rules surrounding these of course, but you get the basic idea.
As you will recall from the Romney example, he earned $0 in wages (35% rate) and millions from investments (15% rate). That right there is a major key in uncovering how his effective rate is so low.
Business Income (and expenses)
Businesses, including personal businesses, are able to write off costs against the revenues they produce before paying taxes. This differs pretty drastically from individuals, who for instance don’t get to reduce their wages on their 1040s by the cost of their rent.
By structuring personal assets and activities as businesses, the wealthy take advantage of this difference in the tax code. A vacation becomes a “business trip” to look after the rental property, reducing the income earned by renting that property by the cost of the trip. A dinner out becomes “business entertainment” if work played at least some part in why you got together. This isn’t to say these characterizations aren’t authentic – it’s just that they aren’t replicable for many Americans who earn a wage in a regular 9-to-5.
Another method to pay fewer taxes or defer them until later years is to invest in publicly traded partnerships (PTPs). The accounting rules surrounding these can be complex, but the biggest upside of a PTP is that any distributions from these companies (basically their unique form of dividends) are seen as a “return of capital.” That allows a taxpayer to avoid paying the Capital Gains tax when the distributions are received, and instead paying them when you actually sell the stock instead. Using this strategy, you can defer taxes for years.
However, it should be noted that one downside is that as a shareholder of a PTP, you will have to pay taxes on the partnership’s current year earnings. Thankfully, the distributions paid to you generally exceed the tax you will owe on income, so you can successfully defer the taxes on income. You will have to pay taxes on the distributions eventually, but remember that typically paying taxes later is better than paying taxes now for both time value reasons and because people typically enter lower tax brackets as they grow older and retire.
Finally, the rich sometimes take advantage of complex systems of trusts to help them shelter their earnings from being taxed. The basic idea is that you set aside some money, give a “trustee” control over the money, and after a certain amount of time (or upon your death) someone will receive the money (the “beneficiary”). Things get complicated from there, however. There are more types of trusts than you might realize – like the Charitable Remainder Unitrusts with Net Income Make-up Provisions (“NIMCRUT”), for instance.
The most common type of trust is an irrevocable trust which allows your loved ones to escape estate taxes when you die. If you’ve got money set aside for your children that you’re not going to touch, why not protect it from taxes? You will need to pay a “gift tax” on the contribution of property to the trust, but if the property is expected to grow over time, it may be beneficial to create a trust today rather than pay estate taxes later.
It is typically expensive to set up a trust, however, so it takes a large sum of money to make most of them worthwhile to set up.
Help For Everyone Else
While it doesn’t necessarily get as exotic as trusts, PTPs, and the like, there are still plenty of ways everyday Americans can be more tax efficient.
If you’re curious about how you can save some money this year, don’t wait until tax season rolls around. Start using GoodApril’s tax savings tools to find ways you can save money and stay on top of the ever-changing tax code.
Other resources for those helping to understand how millionaires pay less taxes:
Mansion Photo Credit: DG Jones