Many disapprove of tax breaks for the wealthy. Image source: Brian Sims, via Wikimedia Commons.
The U.S. income tax system is designed to have those with high incomes pay higher rates of tax than those in lower tax brackets. Yet year after year, many of the wealthiest Americans find ways to pay relatively little in taxes as a percentage of their massive income. Let's take a look at some of the strategies that the rich use in order to keep their taxes as low as possible.
Make the most of investment income
The simplest way that the 1% manage to keep their tax rates as low as they do is by taking advantage of favorable treatment of certain types of investment income. Specifically, even though interest on bonds and bank accounts typically incurs tax at your ordinary income tax rate, dividend income and profits from selling stock that you've held for longer than a year at a gain are taxed at lower rates. For top-bracket taxpayers, the savings is substantial, cutting what would be a 39.6% tax bill nearly in half to the top long-term capital gains and qualified dividend income rate of 20%.
You can benefit from the same advantage, although many won't get as much of a break. Those in the 10% and 15% brackets pay 0% tax on dividends and long-term capital gains. If you're in the 25% to 35% tax brackets, you'll pay a 15% maximum tax on those items.
Use your tax-deferred accounts wisely
Most people invest in retirement accounts like IRAs and 401(k) plans, but few take full advantage of the opportunity they provide. Many 1%ers use their retirement accounts to invest in high-growth start-ups before they go public, getting in on the ground floor and giving themselves the potential for immense returns. If you use a Roth IRA to do so, then all of those gains become tax-free. Some astute wealthy investors have parlayed IRA rollovers from corporate 401(k) plans into tens of millions of dollars by buying closely held stock in what later became highly successful publicly traded companies.
If you have an opportunity to participate in an investment that's off the beaten path, a self-directed IRA can often let you take tax-favored retirement money and use it for investing. Don't expect traditional brokerage firms to offer these self-directed IRAs, but specialty companies will consider allowing you to invest in closely held business interests, real estate ventures, and other investments beyond the stock, bond, and fund arenas. These investments can be risky, but often, the potential tax-free or tax-deferred payoff will justify the extra risk.
Get paid in a tax-friendly way
The 1% have high incomes, but most of what they bring in is rarely in the form of cash. Instead, the rich often rely on alternative compensation to reward themselves for their efforts, and the way they structure their compensation packages can result in much better tax treatment down the road.
For instance, many executives end up taking stock-option packages to supplement their corporate salaries. In a typical deal, an executive will receive options that they can exercise for up to 10 years after they're granted, with the options vesting over a shorter period of time.
Even though those options have value, the executive doesn't have to report them as taxable income immediately. For nonqualified stock options, tax is due when the executive exercises the option, and future gains in the stock obtained through the option exercise can qualify for lower-rate capital gains treatment. For incentive stock options, you can often avoid tax even after you exercise the option, waiting until you actually sell the stock. Either way, you get free tax deferral and a potential lower rate of tax by accepting options rather than cash or other forms of compensation.
These tax secrets aren't available solely to the 1%, but few others have the wealth to make using them cost-effective. Given how much money is at stake for the ultrawealthy, using these secrets saves millions of dollars in taxes for the members of the 1% who use them.
