Stories about millionaires and billionaires who pay little or no income tax make great headlines, especially when these people have committed tax fraud. However, the methods that most wealthy taxpayers use to reduce what they owe are perfectly legal tax-lowering strategies that anyone can use. (For more, read Safe Tax Planning For High-Net-Worth Filers.)
TUTORIAL: Personal Income Tax Guide
Taxpayers may donate up to 50% of their adjusted gross incomes (AGI) according to IRS publication 526, Charitable Contributions. Deductions for donations exceeding 50% of a taxpayer's adjusted gross income can be carried over for the next five years until they are used up. When carryovers are included, contributions are still limited to 50% of AGI per year. Most people cannot afford to donate anywhere near 50% of their AGI, but the super-rich have this option.
While making a large charitable donation helps wealthy taxpayers significantly lower their tax bills, it's not as if these taxpayers are keeping the money for themselves and not paying taxes on it. The government may not get as much revenue, but it has granted taxpayers permission to give it less revenue in this circumstance.
Both the government and private charities run many programs intended to help people with limited means. Well-managed charities have lower administrative costs than government bureaucracies, and that means they can do more good with the same amount of money. Charities also have an incentive to use donated funds as efficiently as possible because they must compete with each other for contributions, whereas government welfare agencies have a monopoly. Thus, we shouldn't be upset when the wealthy pay lower taxes because of their large donations to charity. This tax deduction helps to provide more assistance to people who truly need it. (To learn more, read Deducting Your Donations.)
Maxed-out Retirement Plan Contributions
The average taxpayer might have difficulty making the maximum $16,500 annual pre-tax contribution to an employer-sponsored 401(k) or even maxing out a traditional IRA with its low $5,000 a year pre-tax contribution limit. High-income taxpayers, on the other hand, often have no trouble maxing out their retirement accounts because their essential expenses like food and housing make up a lower percentage of their incomes.
People who earn income as independent contractors or who have their own businesses have even better opportunities to make large retirement contributions. These options are not exclusively available to the rich; they are also available to taxpayers of lesser means. It's just that the latter group may not be able to afford to take full advantage of tax-advantaged retirement contributions for the self-employed since they don't have as much disposable income.
"Wealthy consultants, solo practitioners and business owners, especially those who are close to retirement, might consider establishing a defined-benefit pension plan," says Jonathan Bergman, a Certified Financial Planner and vice president of Palisades Hudson Financial Group, a wealth management firm in Scarsdale, N.Y.;Atlanta, Ga.; and Ft.Lauderdale, Fla. "Self-employed consultants and physicians' practices are ideal for this type of plan."
Such plans permit very large retirement plan contributions for owners who can afford to stash the money away until they're older.
"Retirement-plan contributions reduce current year taxable income, and once the money is in the plan, it is not taxed until it is withdrawn. This income tax deferral can reduce or even avoid state income tax permanently if the contributor relocates to a tax-friendly state during retirement," says Bergman. (For more, check out New Retirement Plan Limits For 2011.)
Some wealthy people are able to pay taxes on a lower percentage of their incomes than the non-wealthy because the wealthy generate significant earnings from investments that are taxed at a lower rate than employment income. The non-wealthy get most of their income from employment.
The money you earn from a job is subject to federal and state income taxes. The more you earn, the higher the tax rate you pay on the last dollar you earn.
Regardless of how much you make, employment income is also subject to payroll taxes (FICA), which are currently 6.2% for Social Security and 1.45% for Medicare. Self-employed workers pay almost double those amounts since they have to pick up the employer's share of the tax. Employees lose out on the higher wages and salaries their employers could have paid them if not for the additional tax.
Investment income is subject to different tax rates depending on the type of investment, how long it was owned and the investor's marginal tax rate, but the rates are often substantially less than the rates on employment income. Here are some examples of the federal tax rates on different types of investment income:
- Qualified dividends: 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else
- Long-term capital gains: 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else
- Tax-exempt municipal bond interest: 0%
Also, while interest income from U.S. Treasuries is subject to federal income tax, it is exempt from state and local income taxes. This feature can help taxpayers in high-tax states and localities reduce their tax bills.
As you can see, investments are generally taxed at a lower rate than employment income. If you start building an investment portfolio, over time, your investment returns might generate a significant portion of your income, too. When they do, you'll be glad that this income is taxed at a more favorable rate. (If you would like to learn more about investing, read Beginner's Guide To Tax Efficient Investing.)
The Bottom Line
Many of the strategies that millionaires and billionaires use to reduce their taxes are perfectly legal and available to everyone, but taxpayers with modest incomes may not have the resources to take advantage of these techniques. Not everyone can afford to make large donations and retirement contributions or to hire sophisticated financial planners and tax accountants, but that doesn't mean that the wealthy are tax criminals.
Additionally, the wealthy may be less afraid to take advantage of every possible deduction because they have the resources to defend themselves against an IRS audit, but again, that doesn't make them tax evaders. Furthermore, tax evasion is not a crime of the super-rich. People at all income levels refuse to pay the taxes they owe, whether they do it by not filing a return, filing a fraudulent return or attempting to circumvent the tax code. These people usually get caught and have to pay up sooner or later. The rest of us could learn something about legal tax minimization strategies from those who employ them. (For tax issues you can avoid, read The 7 Most Common Tax Mistakes.)