The US tax code is designed to collect higher taxes from higher income households. With tax brackets on the low-income side ranging from 10% to 37% for the wealthy, “high-income Americans face higher tax rates and pay more in federal income taxes,” says the nonprofit Tax Foundation.
So, why do we hear about the rich paying less tax?
To understand how millionaires often reduce their taxes, it’s helpful to look at the strategies and advice they receive. Here are some tax tricks that millionaires use to reduce their tax burden.
Read more: How billionaires get away with paying less income tax
Savvy investors understand asset allocation: managing risk by using a portfolio of investments that balances the portfolio for volatility and long-term returns.
Brian Schultz with Plant Moran Wealth Management says millionaires are taking asset allocation to the next level: tax efficiency.
One strategy: Assets that generate high cash flow are parked in tax-deferred retirement accounts such as IRAs and 401(k)s.
“They don’t get taxed on the income right now, and then if they leave it to charity, they don’t get taxed at all,” Schultz told Yahoo Finance. He also notes that low balances in tax-deferred accounts can reduce required minimum distributions at age 73, which triggers income taxes.
At the same time, high-growth investments are held in taxable accounts.
He added: “If I get a portfolio of stocks or mutual funds in taxable accounts, and sell them to provide assets for my living expenses, I get a capital gains rate on the growth. If I don’t spend the money and I sell it, I take a step forward (at death), so the growth is never taxed.”
Attorney and financial advisor, Sharon Winsmith of Winverse Online Financial Education, agrees.
“Do everything possible to avoid accumulating large balances in 401(k) plans or traditional IRAs,” Wainsmith said. “If you have a large balance, I would recommend doing backdoor Roth-IRA conversions to get as much money out of traditional 401(k) and IRA plans as possible.”
For millionaires with large unrealized gains in taxable investments, tax avoidance takes extra effort.
“Even though capital gains taxes are lower than ordinary income taxes, you still pay taxes,” Schultz said. “There is an option where the buyer can borrow against their assets to finance their lifestyle.”
For example, an investor with a $20 million stock portfolio who wants to spend $200,000 a year in retirement can use the assets as collateral for the loan. An investor borrows $200,000 at 7% interest. He might pay $14,000 in interest that year — but zero taxes.
“At the end of the year, I’ve still grown all my assets, but I now have a $200,000 credit against my investments. I had no income taxes because I didn’t sell anything — so I had no gain to recognize. And I had no taxable IRA distributions,” Schultz said.
The strategy is called buy, borrow, die.
“This strategy allows you to pass assets to your heirs without ever having to pay capital gains taxes on the appreciation of those assets. This strategy encourages you to be a disciplined investor and encourages you to only buy assets that you will own for the long term, helping you avoid making short-term, emotional investment decisions.”
Read more: How is dividend tax paid?
Wealthy investors also use trusts to minimize taxes. Some trusts may have highly appreciated stock – with no step-up in cost basis for heirs. This can leave heirs with a large capital gains tax bill.
Schultz said that in a donor trust, a strategy known as an alternate power can allow the transfer of assets of equal value. By switching to cash, bonds, or other assets that don’t appreciate much, heirs can avoid a tax shock.
“So yeah, my heirs won’t be stepping up on that $5 million in assets, but there’s very little unrealized benefit anyway,” Schultz said. “But I put the $5 million in stock that grew over time back into my estate. Now my heirs will get a full step up in the basis … and help reduce the tax that my family or my heirs will pay.”
One tax trick the rich are very adept at: reducing—or moving—personal income into a lower tax bracket.
“Under the current tax laws, I recommend looking for every possible opportunity to convert earned income or self-employment income or business income,” Wainsmith said. “W-2 wage income is taxed at a high rate and is the least efficient way to earn money.”
She noted that many small and medium-sized companies are willing to structure compensation so that you are treated as an independent contractor.
“This allows you to take advantage of tax deductions otherwise unavailable to full-time employees, such as the expense deduction, the qualified business income (QBI) deduction, and the home office deduction,” she added.
With the federal estate tax exemption now capped at $15 million ($30 million for married couples), if a wealthy person has two children and wants to leave $5 million each, anything over that $10 million given to charity is tax-free.
“It’s an effective estate plan, it’s tax-efficient,” Schultz noted.
However, he says that making charitable donations during your lifetime is actually more tax-deductible.
“If they were willing to make some donations to charity while they were alive, now you get those assets out of your estate, and you get an income tax deduction for the charitable donation,” he added. “Honestly, a lot of times it’s a mindset shift for customers when they first think about it. They see that some of their money is going to work to support causes they care about.”
