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How the wealthy slash their taxes

The rich use a variety of strategies, all perfectly legal and available to everyone, to reduce the size of their income tax bills.

By MSN Money Partner Dec 28, 2011 4:23PM

This post comes from Amy Fontinelle at partner siteInvestopedia.

 

InvestopediaStories about millionaires and billionaires who pay little or no income tax make great headlines, especially when these people have committed tax fraud. However, the methods that most wealthy taxpayers use to reduce what they owe are perfectly legal strategies that anyone can use.

 

Charitable donations

Taxpayers may qualify for a tax deduction when they donate up to 50% of their adjusted gross incomes, according to IRS publication 526, Charitable Contributions. Deductions for donations exceeding 50% of a taxpayer's AGI can be carried over for the next five years until they are used up. When carryovers are included, contributions that qualify for a deduction are still limited to 50% of AGI per year. Most people cannot afford to donate anywhere near 50% of their AGI, but the super-rich have this option.

 

While making a large charitable donation helps wealthy taxpayers significantly lower their tax bills, it's not as if these taxpayers are keeping the money for themselves and not paying taxes on it. The government may not get as much revenue, but it has granted taxpayers permission to give it less revenue in this circumstance.

 

Both the government and private charities run many programs intended to help people with limited means. Well-managed charities have lower administrative costs than government bureaucracies, so they can do more good with the same amount of money. Charities also have an incentive to use donated funds as efficiently as possible because they must compete with each other for contributions, whereas government welfare agencies have a monopoly. Thus, we shouldn't be upset when the wealthy pay lower taxes because of their large donations to charity. This tax deduction helps provide more assistance to people who truly need it.

 

Maxed-out retirement plan contributions

The average taxpayer might have difficulty making the maximum $16,500 annual pretax contribution to an employer-sponsored 401k or even maxing out a traditional IRA with its low $5,000 pretax contribution limit. High-income taxpayers, on the other hand, often have no trouble maxing out their retirement accounts because their essential expenses such as food and housing make up a lower percentage of their incomes.

 

People who earn income as independent contractors or who have their own businesses have even better opportunities to make large retirement contributions. These options are not exclusively available to the rich; they are also available to taxpayers of lesser means. It's just that the latter group may not be able to afford to take full advantage of tax-advantaged retirement contributions for the self-employed since they don't have as much disposable income.

 

"Wealthy consultants, solo practitioners and business owners, especially those who are close to retirement, might consider establishing a defined-benefit pension plan," says Jonathan Bergman, a certified financial planner and vice president of the wealth-management firm Palisades Hudson Financial Group. "Self-employed consultants and physicians' practices are ideal for this type of plan."

 

Such plans permit very large retirement plan contributions for owners who can afford to stash the money away until they're older.

 

"Retirement-plan contributions reduce current year taxable income, and once the money is in the plan, it is not taxed until it is withdrawn. This income tax deferral can reduce or even avoid state income tax permanently if the contributor relocates to a tax-friendly state during retirement," says Bergman.

 

Investment income

Some wealthy people are able to pay taxes on a lower percentage of their incomes than the non-wealthy because the wealthy generate significant earnings from investments that are taxed at a lower rate than employment income. The non-wealthy get most of their income from employment. Post continues below.

The money you earn from a job is subject to federal and state income taxes. The more you earn, the higher the tax rate you pay on the last dollar you earn.

 

Regardless of how much you make, employment income is also subject to payroll taxes, which are currently 6.2% for Social Security and 1.45% for Medicare. Self-employed workers pay almost double those amounts since they have to pick up the employer's share of the tax. Employees lose out on the higher wages and salaries their employers could have paid them if not for the additional tax.

 

Investment income is subject to different tax rates depending on the type of investment, how long it was owned and the investor's marginal tax rate, but the rates are often substantially less than the rates on employment income. Here are some examples of the federal tax rates on different types of investment income:

  • Qualified dividends -- 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else.
  • Long-term capital gains -- 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else.
  • Tax-exempt municipal bond interest -- 0%.

Also, while interest income from U.S. Treasuries is subject to federal income tax, it is exempt from state and local income taxes. This feature can help taxpayers in high-tax states and localities reduce their tax bills.

 

As you can see, investments are generally taxed at a lower rate than employment income. If you start building an investment portfolio, over time your investment returns might generate a significant portion of your income, too. When they do, you'll be glad that this income is taxed at a more favorable rate.

 

The bottom line

Many of the strategies that millionaires and billionaires use to reduce their taxes are perfectly legal and available to everyone, but taxpayers with modest incomes may not have the resources to take advantage of these techniques. Not everyone can afford to make large donations and retirement contributions or to hire sophisticated financial planners and tax accountants, but that doesn't mean that the wealthy are tax criminals.

 

Additionally, the wealthy may be less afraid to take advantage of every possible deduction because they have the resources to defend themselves against an IRS audit, but again, that doesn't make them tax evaders.

 

Furthermore, tax evasion is not a crime of the super-rich. People at all income levels refuse to pay the taxes they owe, whether they do it by not filing a return, filing a fraudulent return or attempting to circumvent the tax code. These people usually get caught and have to pay up sooner or later. The rest of us could learn something about legal tax minimization strategies from those who employ them.

 

More on Investopedia and MSN Money:

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13Comments
Dec 30, 2011 6:31PM
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Even for us that are average wage earners, if you expect to build any wealth over your life time for retirement or whatever, you have to have a tax strategy. the first year I worked as an 18 year old I made $15,000 and last year I made much much more but I have always had a tax strategy for every income bracket I was in that was formulated the year before. Thanks to this I have been able to put away  a significant amount for retirement. You just can't build up resources if you are paying the tax rate that you fall into based on income.
Dec 30, 2011 4:24PM
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But, you have to be money wise to be wealthy.
Dec 29, 2011 12:14AM
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Good points.  I use all of them.  
Dec 30, 2011 4:23PM
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You don't have to be wealthy to be money wise but it sure helps.
Jan 3, 2012 11:50AM
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Steve,

 

Incomes deriveted from investments have ALREADY been taxed as real income once.  If they do short term investments (less than 1 year) they are still taxed at the higher rate.   As said below, the only way to win is to save a percentage of your money.  If you don't have a company plan, save under a ROTH and it won't ever be taxed...If you contribute $5000 a year for 40 years at 5% return, at 65, you would be able to pull $50K a year for at least 20 years at ZERO Tax...Lower than Buffet!

Jan 4, 2012 1:47PM
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"As you can see, investments are generally taxed at a lower rate than employment income. If you start building an investment portfolio, over time your investment returns might generate a significant portion of your income, too. When they do, you'll be glad that this income is taxed at a more favorable rate."

 

-- OR maybe employment taxes should be lower, so that more of Americans can actually create some kind of investment portfolio, no matter their income.

 

Trickle down economics DO NOT WORK. History shows us this time and time and time again. This strikes me as similar if not the same.

 

It simply is not fair that those with more income that is generated by investments somehow 'deserve' to not pay fair and equitable percentages in taxes.

Jan 4, 2012 4:27PM
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Most deductions are a not that big of a deal. Most are designed to show you only a percentage of the actual debt. This includes the housing deduction, charitable deductions ect. Investment income taxes of 15% are a good deal, but they do carry a risk of market and return fluctuations. I would consider it a trade off because instead of a fixed salary you are gambling on a fluctuant return. The 401k is taken off the top of your income and not taxed until you begin to draw it out. Some will say it is a fluctuant vehicle but by the time you are able to start drawing it out you should not be in volatile investments anyway. If life insurance and flex spend accounts are available through your work they are good tax reducing options for you also.

 Personally, I think our tax code is way too complicated and a simple flat tax would be better. That way ALL of us, rich and low incomes alike pay. 

Jan 4, 2012 10:59AM
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None of those suggestions are useful to me- as an enlisted active duty military member, I cannot afford to do any of those, nor do I have investment income. But at least not all my income is taxable- my only consolation. Thanks Uncle Sam.
Jan 26, 2012 10:45AM
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BLESS THIS OLIGARCHY AND PLUTOCRACY!

JUST WHAT JESUS AND OUR FOREFATHERS WANTED RIGHT?

RIGHT????

Jan 26, 2012 10:45AM
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In this oligarchy do like 90% of the wealthy have done:

LIE
CHEAT
STEAL
RINSE
REPEAT
WALLA!

Facts are IF your moral and ethical you WILL fall behind the rest of the criminal plutocratic capitalists that do not play by the rules..just the way it is..

Remember its "dog eat dog" and "survival of the fittest"?

THOSE WHO LIVE BY THE SWORD...


Jan 26, 2012 10:43AM
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CAN'T WAIT TILL VIOLENT CRIME TRIPLES AND THE RICH WILL BE FORCED TO STAY HOME IN THEIR GATED COMMUNITY'S WITH THEIR STOLEN MONEY..


THOSE WHO LIVE BY THE SWORD???

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Steve...........Stop showing your ignorance, By law "The Bush Tax cuts" ended December 31, 2010.

 

I think you are referring to the Obama Tax Cuts for the rich that he signed into law on December 17, 2010.

Jan 2, 2012 6:26PM
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They forgot to mention the main way they pay less taxes, they get Bush to cut capital gains to ultra low 15% and the more rich people are the more income percentage wise is capital gains. Poor lamost never have capital gains, very little for middle class either. Almost all the capital gains go to the rich and well off and they pay less than people doing real work. Money buys congress and lower tax rates.
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