One of the fundamental tenets of the U.S. tax system is its progressive nature, which typically imposes higher taxes on the wealthy than on low-income Americans. However, some of the most lucrative tax breaks available to taxpayers end up going disproportionately to the wealthiest Americans. In particular, three favorable tax provisions have made tax time a lot less taxing for the wealthy.
1. A big bump in the estate tax exemption amount
The estate tax doesn't get as much attention as the income tax, but it can be even more of a burden to the wealthiest Americans. The tax has historically targeted the rich, but exactly what defines "the rich" has changed dramatically over time. As recently as 2001, a tax rate of 55% applied to estates with assets worth more than $3 million, and lower rates applied to estates with assets totaling just $675,000. Given that in some areas of the country, even a modest home can cost $675,000, many Americans found themselves facing estate tax consequences despite not seeing themselves as particularly wealthy.
Subsequent tax changes eased the burden of the estate tax. For 2017, the lifetime exemption amount from gift and estate tax has risen to $5.49 million. Enhanced provisions allowing married couples to use their total exemption amounts more effectively have made it possible for them to shelter nearly $11 million from estate tax. Moreover, estates that are taxable now pay an effective flat rate of 40%. While that's still higher than the top marginal income tax rate, it's down substantially from its highest levels in the past. Some believe that impending tax reform could take rates down further or even eliminate the estate tax entirely.
Moreover, the wealthy also benefit from the fact that when they inherit, the assets they receive get a step-up in their tax basis, allowing them to avoid having to pay capital gains tax on their sale. Combined, these tax breaks don't eliminate tax on the wealthiest Americans, but they've made a big dent in what could sometimes be a large tax bill.
2. A low limit on having to pay Social Security payroll taxes
One area where the wealthy benefit substantially is in the way that Social Security payroll taxes get charged. Most wage earners and self-employed workers have to pay taxes of 6.2% and 12.4% respectively that go toward the Social Security program, along with an additional 1.45% and 2.9% respectively for Medicare. Medicare payroll taxes are imposed on an unlimited amount of salary or earnings. However, there's a limit on the wages subject to Social Security, which for 2017 is $127,200.
It's true that in exchange for not having to pay Social Security tax, the wealthy don't get any credit for the extra money they earn for purposes of calculating their eventual retirement benefit. However, some reform efforts have targeted what's known as the wage base limit, suggesting that either raising the amount or imposing a surtax that takes effect above a higher income limit could generate much-needed revenue to help make Social Security more financially viable in the long run.
3. Extensive tax breaks related to investing
Anyone can take advantage of favorable tax provisions related to investing, but the wealthy are in the best position to use them. There are a number of things that the wealthy get big benefits from, including the following:
- Lower maximum long-term capital gains tax rates on investment assets held for longer than a year. Current maximums of 20% compare favorably to the 39.6% that high-bracket taxpayers have to pay on short-term capital gains.
- Lower maximum tax rates on qualified dividend income, matching the long-term capital gains rates listed above.
- Roth IRAs for retirement, health savings accounts for healthcare costs, and 529 plans and Coverdell Education Savings accounts for educational expenses offer tax-free distributions that give the greatest benefit to those in the highest tax brackets.
Indeed, those who have enough money to live off their investments often end up paying less in taxes than those who have to work and earn wage and salary income, and these and other tax provisions are to blame. The impact of tax reform on these provisions is unclear at the moment, with possibilities that these breaks could either grow or shrink as part of a broader reform package.
The wealthiest Americans pay plenty of taxes, but these tax laws help them cut their tax bills. Until tax reform makes changes to these and similar provisions, the wealthy will be able to use these tax breaks to pay a little less to the IRS in April.