What are strategies the rich use to avoid as much income tax as possible? When the wealthy have marginal tax rates north of 30%, it’s amazing how much low tax rate income they must have to bring that number down into the low teens.
Here are a handful of strategies that they use that, while not always 100% accessible to the average person, are at least within the realm of possibility:
1. Build a strong network
I wanted to start the list off with something that anyone can do but that the wealthy, especially those who derived their wealth in business, do very well – networking. One thing you’ll recognize very quickly is that the most successful individuals often know the most number of people. While it may appear that it has to do with the wealth they’ve generated, that’s often the result of the network itself. Think about some of the more successful people in your workplace, the people who can “get things done” and a lot of it has to do with the other people in the organization that they know. When I worked at large companies, some people were able to circumvent the arduous process cycles to get their work at the head of the line or completed with extra attention to minimize errors. It’s entirely based on networking (read: friendships).
And networking is a delicate process. We all know about the guy who introduces himself and within minutes has his business card in your hand. Or the friend who just joined a multi-level marketing “business” and wants you to buy [insert products here]. Networking is about being a nice person, finding out what other people do, and then, at some later time, figuring out if you can work together. You have to build a network before you need it because rushing the process will turn people off. (what this really means is just be nice to people and don’t think about networking as building a network, think of it more like making a lot of friends that you hope, one day, you can help somehow in a tangible way)
This will be the only non-directly financial strategy of the list… so enjoy it.
2. Harvest investment losses
No one ever bats 1.000, so when you make a lot of investments, some of them will not pan out. Fortunately, you can use the losers to offset some of the winners and take some of the edge off that loss. Harvesting investment losses are pretty easy, you just have to watch out for the wash sale rule. If you have more losses than gains, you’re able to take $3,000 of that against your income. But wait… there’s more! As an added bonus, you can carry forward losses indefinitely. So if you recognize $10,000 in stock losses this year, you can reduce your income by $3,000 and then carry the $7,000 into next year.
Unfortunately, you can’t take advantage of this in tax advantaged accounts like a 401(k) or an IRA. Since you typically don’t recognize gains or losses in those accounts, you can’t use them to your advantage either. You end up on the better side of that trade off because you don’t have to pay taxes and reduce your investment amount, each time you transact.
3. Defer income
Deferring income sounds easy but not all of us have the income to defer. The wealthy typically take advantage of their flexibility by timing the sale of their assets, like stocks, for when it’s most beneficial. Selling a stock on January 1st, 2019 means you don’t have to pay for it until April 2020 – that’s over a year later (they make sure that they pay enough taxes to avoid any penalties).
When you get paid a salary from your employer, you get a regular paycheck and your income comes in on a regular basis. You can’t, usually, opt to get paid later just for the tax benefits. You can, however, defer a little bit of income by contributing more to retirement accounts. Every dollar you contribute to your 401(k) is a dollar you won’t have to pay for until you retire and start taking disbursements from your account.
4. More long-term capital gains, less ordinary income
Why does Warren Buffett pay a lower percentage of his income in taxes than his administrative assistant? Long term capital gains. When you own a stock for more than a year and sell it, you are taxed at a much lower rate. When you start a business and sell it after a year, that’s usually long-term capital gains. When you’re paid a salary and issued a W-2 at the end of the year, that’s ordinary income. Ordinary income tax rates are much higher than long-term capital gains rates.
Unfortunately, there’s very little you can do to change this because it’s not like you can quit your job, start a business, and start paying lower rates. What you can do is start taking some of your savings and, based on your appetite for risk, invest in dividend stocks as a way to general income that is taxed at long-term capital gains rates. It’s riskier than a CD but it offers up higher yields coupled with a lower tax rate.
5. Avoid expensive debt
Avoiding expensive debt is easy when you have a lot of cash on hand. The wealthy may have plenty of loans, usually favorable ones with single-digit interest rates like home mortgages, but they will rarely carry credit card debt charging double digits. It simply doesn’t make financial sense to pay 19.99% when you have cash in the bank.
The takeaway from this is that everyone should be avoiding double-digit interest rates. Live without that special something until you can pay for it all at once or get a favorable loan to buy it.
6. Create multiple streams of income
Have you seen the tax returns of some of the Presidential hopefuls throughout the years? Very few of them derive their income from one job. They often take on different roles and generate income from a variety of methods, to include investments in the stock market. Multiple streams of income, especially if they are mostly passive, is valuable because it makes your financial status more stable. Losing one stream, such as your main job, won’t be pleasant but it doesn’t derail the entire system.
The takeaway from this is that you should always be investigating avenues of generating additional income. Whether that’s something as straightforward as investing in dividend stocks for a little trickle of income to starting a side venture that generates a larger torrent of income, the constant search is what matters. Always be investigating and learning.
7. Consider heirs
There are a variety of investment vehicles, life insurance policies, and other financial games the wealthy can play when it comes to estate planning. In many cases, those games are on the pricier side but they come with significant tax benefits. Tax benefits that outweigh the cost of the vehicles themselves. For example, permanent life insurance plans (plans where a sum is paid out at the end of the policy and where the plan accrues a cash value – so whole life and universal life, but not term life) let you accrue value without paying any taxes until that value is withdrawn. It’s a way for you to defer income (in this case, the income that would come from the increase of cash value in the life insurance plan, not cash you contribute), see gains, but not be taxed on them until the plan ended.
So how is this related to considering your heirs, rather than deferring capital gains? When you die, the death benefit that is paid out to a beneficiary is not included as income for that beneficiary (it is, however, still included as part of the estate). You can avoid this if you involve a certain type of trust (it starts to get more complicated than I prefer to get and outside my area of expertise, so I’ll defer on this one), but basically you make it the owner and beneficiary of the policy, have it collect the death benefit, and then have the trust manage the money.