According to a White House analysis from 2010 to 2018, 400 of the wealthiest families in the U.S. paid an average of 8.2% on their federal individual income taxes. The average effective tax rate was $1.8 trillion of income over nine years.
The same research also revealed that 25 of the wealthiest citizens paid an effective federal tax rate of 3.4% from 2014 to 2018, while their collective net worth grew by more than $400 billion.
For context, the average American paid a 13.3% tax rate on their income in 2018 (this figure includes all taxpayers, including the wealthiest). Regardless of your stance on the ‘Tax the Rich’ movement, everybody wants to pay fewer taxes.
The rich know how to pay fewer taxes, but which came first: the rich paying less in taxes, or those paying less in taxes becoming rich? Tax planning strategies can go a long way.
Here’s what the rich know about tax laws and how you can apply their techniques to your situation.
Why is the Tax Rate for the Rich So Low?
Before going further, it’s essential to examine the figures above closely. Given the top federal income tax rate is 37%, why aren’t the wealthy paying at least that much?
The wealthiest Americans generate the bulk of their income from investments. If those investments are held for a year or longer, they will only pay long-term capital gains at a rate of 20%. So, why aren’t they paying 20% instead of less than half that?
The White House report includes income from “unrealized capital gains,” which departs from typical income analyses. If one of these persons owns 10,000 shares of stock ABC, which appreciates from $20 per share to $40 per share, and they do not sell, the report counts that as $200,000 worth of income.
By doing this, the investigators raised the target group’s “income” (which no taxes were paid on) and used that figure in their calculations, considerably lowering the resulting effective tax rate. Replicate that logic over the entire demographic, and you get staggering results like 8.2% and 3.4% tax rates.
Now that we have that straight, let’s go over the most popular strategies the wealthy use to lower their tax bills and how you can do the same.
5 “Rich” Strategies for Lowering Your Tax Bill
The IRS has no problem with you avoiding as much taxation as is legally allowable. Understanding which tax breaks currently or could apply to you may differ in thousands of dollars saved each year.
1. Tax Planning
The single best way to pay less in taxes is to prepare in advance. This is known as tax planning, and it should be part of every household’s financial plan. It also may be the #1 contributor for why the rich pay less.
As opposed to tax preparation (which is what you or a tax professional does retroactively every year in April), tax planning proactively takes the guesswork out of how much you will pay at the end of the year. Doing so may help you take advantage of tax deductions, rebates, credits, concessions, and/or exemptions.
Anyone liable to pay taxes would probably benefit from some form of tax planning. Without it, you may end up paying more than necessary.
2. Investment Income
It may be time to step up your investment income like the ultrawealthy.
Unsurprisingly, the higher you go up the income ladder, the greater the share of income is derived from capital gains. This results in a lower effective tax rate.
Make more money, invest it, then live off your investments. Simple, right? I never said it would be easy.
In the same vein, business income and distributions are also frequently taxed at lower rates.
3. Maximizing Tax Efficiencies
This will be a significant portion of your tax planning process if you start doing it.
The IRS has blessed us: 401(k)s and 403(b)s, IRAs, HSAs, and TSPs are the most common tax-efficient vehicles available to us – take advantage of them.
These powerful tools can rapidly increase the value of your retirement portfolio. You can be sure, if they’re eligible, that the rich are using each of these.
My general rule of thumb: if the IRS has placed a contribution limit on it, you should be contributing to it.
4. Tax “Loopholes”
Here’s a news flash for you: The United States has a complicated tax code. However, its complexity has created “loopholes.”
Tax loopholes are just legal ways for reducing tax liability – though some are certainly more ‘gray’ than others. More often than not, we should just call them tax breaks.
Mortgage interest deductions, home-sale exclusions, charitable giving, the Saver’s Tax Credit, the Earned Income Tax Credit, the American Opportunity Tax Credit, the Lifetime Learning Credit, the Child Tax credit, and the list goes on.
The bottom line: the rich know which breaks apply to them and make sure to use them. You should do the same.
5. Charitable Contributions
You are eligible for an income tax deduction when you donate to a qualified 501(c)(3) charity. You can reduce your taxable income (and corresponding tax bill) and improve the world while you’re at it.
Charitable giving will only reduce your tax liability if you itemize your deductions. When your combined deductions (including philanthropic gifts) add up to more than the standard deduction, you will choose to itemize.
See the 2022 standard deduction amounts shown in the chart from www.irs.gov.
A Final Note
The subject of taxes is essential, so don’t glaze over when you are considering these get-rich tips. Proper tax planning has one of the highest ROIs (return on investment) in the financial world. Many people save themselves thousands of dollars every year, money put towards savings, investments, or fun.
If you don’t want to do the work yourself, talk to your tax-savvy financial advisor. We know the tax code and can help you keep your entitled money. Not to mention, do you know a wealthy person who doesn’t employ a financial professional?