Among investors, there may be none more revered than Warren Buffett. Although recent stock market weakness has pushed Buffett well behind Bill Gates for the title of richest person in the world, there's little denying that Buffett has been nothing short of masterful for turning a fortune of less than $10,000 in the 1950's into a net worth of nearly $61 billion today, according to Forbes.
Much of the credit for Buffett's success goes to his and his teams' ability at Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) to recognize quality companies trading at a discount.
Warren Buffett. Image source: The Motley Fool.
For example, since 1988 Buffett and his team have gobbled up 400 million shares of beverage giant Coca-Cola (KO 0.16%). Coca-Cola's days of rapid growth are well in the rearview mirror, but with a presence in all but one country around the globe (North Korea), and more than 3,000 unique beverages, product diversification and inelasticity have worked in Buffett's and Berkshire's favor regardless of the economic environment. On a split-adjusted basis, Buffett's initial investment in Coca-Cola is up more than 20-fold, and Berkshire Hathaway is now reaping $528 million in dividend income annually, which builds upon Coca-Cola's 53-year streak of raising its annual payout.
And you can trust me when I say there are many more Coca-Colas in Buffett's portfolio.
Warren Buffett's secret to paying a lower tax rate than you
But stock picking is just one reason Buffett's been able to amass such incredible wealth. The other component to Buffett's success is an exceptionally low effective tax rate. As noted by the Oracle of Omaha himself in an op-ed column in The New York Times in 2011, Buffett claimed to be paying only a 17.4% effective tax rate (that year) compared to 20 workers in his office who were paying an average tax rate of 36%.
In Buffett's own words:
If you make money with money, as some of my super-rich friends do, your [tax] percentage may be a bit lower than mine. But if you earn money from a job, your percentage will surely exceed mine -- most likely by a lot.
Although our progressive income tax brackets have changed a bit since Buffett wrote this piece in 2011, this basic tenet still holds true: Buffett, one of the richest people in the world, is probably paying a lower tax rate on his income than you are.
How is this possible? Simple. Buffet takes advantage of capital gains taxes and lengthy stock holding periods.
How capital gains taxes give Buffett an edge
Buffett has often emphasized the importance of long-term investing in his shareholder letters and annual meetings. Putting into practice what he preaches has made a big difference when it comes to him paying a far lower tax rate than many Americans.
Buffett himself only takes home a $100,000 salary each year as the CEO of Berkshire Hathaway, although there are other areas where the Oracle of Omaha is compensated. The remainder of Buffett's taxation comes from capital gains taxes.
Capital gains tax rates are pretty cut-and-dried. If you own a stock or bond for one year or less, it's considered a short-term investment. As such, the individual claiming the gain will pay an ordinary income tax rate commensurate with their peak marginal tax rate. For the super-rich today that could work out to a 39.6% tax.
The magic happens when you hold onto an investment for a year and a day or longer. Selling a stock beyond this point and claiming a capital gain allows an investor to substantially reduce their tax liability on the gain. Taxpayers in today's 10% or 15% ordinary income tax bracket would owe zero, zilch, nada, on their long-term capital gains based on the 2016 federal tax tables. Taxpayers in the 25%, 28%, 33%, or 35% ordinary tax brackets owe just 15% on their long-term capital gains. Finally, the super-rich, which would encompass anyone bringing in more than $415,050 as an individual or $466,950 as married filers in 2016, would owe just 20%.
Imagine this for a moment. Let's assume Buffett were to sell stock and claim $1 billion in long-term capital gains. His tax on this amount? Based on 2016's tax schedule, he would be responsible for paying a 20% tax (plus a potential 3.8% net investment income surtax which is tied to the Affordable Care Act). By contrast, a worker with no investment income who earns $37,651 in 2016 finds themselves stuck in a peak ordinary income tax bracket of 25%. Understandably effective tax rates for both individuals would be lower than their peak marginal taxes rates, but this difference clearly shows how long-term capital gains significantly favor the rich. It's a tool that Buffett has used to keep a good chunk of his money.
A holding period of forever helps, too
But, on top of just paying a lower tax rate via capital gains taxes, Buffett's wealth is also a factor of the 0% in taxes he pays by holding stock in companies for very long periods of time (if not forever). If Buffett never sells, he never has to pay any tax, and all the while he gets to benefit from the rising value of the stocks he and his company Berkshire Hathaway owns. Historically, the stock market has risen at a pace equivalent to 7% to 8% per year, meaning a long-term investor could see their money double about once every decade under "average" circumstances.
The good news is Buffett's tax secret really doesn't have to be a secret at all. Anyone can benefit from long-term capital gains as long as they remain disciplined. This means seeking out and investing in businesses not because of some great earnings report or new hot gadget, but because they have a long-term business model/plan that, after careful research, you believe can succeed over the long run. Finding companies with competitive advantages, and that pay regular dividends, is a formula Buffett's used for a long time. You, too, can use it to grow your investment portfolio while also possibly lowering your effective tax rate.
