How the Wealthy Save Money on Taxes
Apr 15th, 2007 by Wealth Builder [This post is written and copyrighted by Wealth Building Lessons (http://www.wealthbuildinglessons.com).]
It’s general belief that wealthy people don’t pay taxes. While this is not necessarily true, what is true is that they usually pay a lot less as a percentage of their income than a single guy making $85,000 a year.
A single guy making $85,000/year pays Federal Income Tax and Social Security Taxes. Assuming he has no deductions, his tax for 2006 comes out $15,766 or about 18.5% average tax rate (and a 28% marginal tax rate).
Compare that with wealthy people who make money from dividends off their stock. Stock dividends are taxed at a flat rate of 15% (if held for over 60 days). You could be making $250,000 a year in dividends and not pay more than 15% tax. Of course, your overall tax is higher, but if all you earn $250,000 from dividends, you’ll end up paying $33,432 in taxes which is only 13.4% of your income.
Of course if you’re like Teresa Heinz-Kerry and earn $5 million from Municipal Bonds, you don’t pay any taxes at all!
But instead of complaining about the unjustness of the tax system, lets figure out what the rich do to save on taxes and how they become even wealthier in the process.
One of the basic steps is Income Splitting. They derive their income from a multitude of corporations and trusts and shelter as much income as they can. (Many of them set up sham charities but they usually end up going to jail like Wade Cook).
They invest in Tax Advantaged Investments.
Investments like Real Estate allow investors to depreciate the value of the improvements over time and defer paying taxes for extended periods of time. Its possible to sell a property with $500,000 in profit and buy a $2 million property in exchange, but pay no taxes and also get a $50,000 write-off for another 40 years!
These write-offs can also be used to reduce the taxes due on earned income. Normally, you’re capped at taking $25,000 in losses against earned income but if you (or your spouse) qualify as a real estate professional (meaning you worked over 750 hours in real estate, and at least 50% of your time in it if you have another job) you get to deduct unlimited losses.
Or you can invest in an Oil & Gas Drilling programs, and write off almost 85% of the first years investment. Not only that but 15% of the subsequent income is tax free!
A combination of some of these investments and tax-free savings like Municipal Bonds can substantially reduce your income taxes.
Wealthy people also don’t have jobs to begin with. They make most of their money from dividends and investments which have preferential tax rates. This helps them keep more of their wealth and it compounds.
They also delay paying taxes for a extended periods of time.
For the most part you only pay taxes on realized gains. Investors like Warren Buffet never sell their holdings so there’s never any taxes due. Then they donate the stock to a charity so there’s no tax consequence at all.
Real estate investors can also defer paying taxes. Any time your property appreciates, you refinance it, pull the money out tax-free and either spend it or re-invest it. Or you can do a 1031 exchange (also called a starker exchange) and roll the profits over into another property. Again tax-free and since most investors leverage into a bigger property, it comes with a new larger set of deductions!
Some enterprising investors also set up self-directed Roth IRAs. This means they pay tax upfront, but then they invest through their Roth IRA, let the money compound tax-free for decades and then pull the money out tax-free. There are also ways to use this to invest in real estate and also businesses (although you need to make sure you aren’t running into UBTI issues, where you’re taxed at 35%).
If you’re at the point where you’re making a lot of money, it’s worth your while to find an experienced tax-planner who can help plan your investments and set you up with an entity to help reduce your taxes.
Related Books
1.Tax-Deferred Investing : Wealth Building and Wealth Transfer Strategies
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3 Responses to “How the Wealthy Save Money on Taxes”
Surely the AMT offsets some of the supposedly preferential rates, though not all of them. There are plenty of mechanisms in the US tax code to reduce tax liability but alos plenty of mechanisms to claw it back again (which isn’t the case in Australia for example). The net result is that generally the rich pay higher rates in the US (look for example at Bush’s tax bill) though tax deferral is big.
A great site, keep up the good work - On this topic of Income splitting, how would a single tax earner in the 25% bracket with no real estate take advantage of this by setting up an entity. Can you provide some practical examples as for a single person. Thank You