How to Avoid Taxes Like the Rich: Top Tax Tips of the Wealthy
The notion that Governor Romney’s wealth enabled him to pay a very low tax rate was given ample press attention in the 2012 election cycle – meanwhile, some 47 percent of the country managed to avoid paying income tax at all.
While you probably don’t want to emulate most of the 47 percent who don’t pay income tax because they don’t make much money to begin with, there are a number of tax tips that wealthy people use to mitigate their tax bills that are available to the middle class too.
This article highlights the top 8 tax tips and measures that are routine among the financially sophisticated, but accessible for the rest of America.
1. Use Schedule C instead of Schedule A
Most of us workers and employees get paid on a W-2 basis. If that’s you, that means your employer takes out your Social Security, Medicare and an estimated federal income tax, sends it off to the IRS every quarter, and rats you out by telling the feds exactly what he’s paying you.
If you’re an independent contractor you get a 1099 instead. You still have to pay all the same taxes – and an additional 6.2 percent courtesy of the self-employment tax. You just have to do the saving yourself. You may get a few extra deductions, since you can put all your business expenses on a Schedule C. If you’re an employee, and you have unreimbursed business expenses, the IRS still nails you, because you have to use Schedule A and therefore you can’t deduct unreimbursed employee expenses until they exceed 2 percent of your adjusted gross income. If you make $50,000 per year as an independent contractor, and you have $1,000 in business expenses, you can deduct all of it from your income, before it even gets to your 1040. You only pay income taxes on what’s left over.
If your situation is identical, but you are an employer working for someone else, and you spent $1,000 on business expenses, you get clobbered: The IRS does not care that you had to spend money out of your own pocket to keep the business going. You will pay taxes on that money anyway, even though you didn’t get to keep it – and your employer didn’t reimburse you.
- Tip: You have to clear that 2 percent of adjusted gross income hurdle on almost any itemized deduction if you have to use Schedule A. For medical expenses, that hurdle is even higher – 7 percent. But there’s no such hurdle for Schedule C. The first dollar is deductible right off the top. Try to structure business expenses as Schedule C expenses, rather than miscellaneous itemized expenses under Schedule A. Having a little side business helps immensely in this process. If you need to buy office supplies, a computer, books, or the like for work, you can make fuller use of the available deduction.
2. Bunch Deductions
If you must use Schedule A to itemize deductions, it may help to bunch as many deductions as possible into the same year. This maximizes the amount of deductions over and above the 2 percent of adjusted gross income threshold, which in turn minimizes your income tax bill. So if you get to December and you have some planned itemized deduction expenses or medical expenses that you know are going to happen within the next twelve months, pull the trigger now. Even if you pull out the credit card and borrow money to make the purchase, bunching two years’ worth of deductible expenses into one year can really make a dent in your tax bill.
- One technique: Try to make itemized deductions only in every other year, to the extent practicable. Schedule medical procedures that take a lot of follow-up care early in the year. That way follow-up care doesn’t get divided between two years, but concentrated as much as possible into one year. (Make sure you spend all available flexible savings plan dollars, too, or you lose them.)
3. Have – and Grow – Your Non-Taxable Income
Many of the wealthy structure their assets to generate as much tax-free income as possible. There aren’t too many tax-free income streams left these days, but there are still a few:
- Roth IRA accounts. You don’t get a tax deduction on the front-end, like you do with a traditional IRA or Roth IRA. But income received from Roth accounts grows free of income or capital gains tax, provided you leave the money in at least five years before withdrawing.
- Roth 401(k) designated accounts. Some companies have begun offering designated Roth accounts in their 401(k) plans that allow you to get the same tax benefits of a Roth IRA – but with much higher contribution limits. Federal employees and military can also now opt to contribute to a Roth version of the Thrift Savings Plan – a sort of 401(k) equivalent for federal workers.
- Municipal Bonds. These are bonds issued by states, counties, cities, and quasi-public agencies for the purpose of building public works. The federal government provides an important subsidy to these entities: They don’t charge federal income tax on interest income from these bonds (for the most part). So if you get a 5 percent yield from a municipal bond, you get to keep all 5 percent. You pay taxes on none of it. If you are in the 28 percent tax bracket, that’s the same, on an after-tax basis, as getting a 7.467 percent yield from a taxable bond. Note that if you are subject to the alternative minimum tax, income from certain kinds of municipal bonds, called private activity bonds, becomes taxable.
- Life insurance death benefits. Death benefits to beneficiaries on a life insurance policy that has not been sold to a third party are generally tax-free.
- Life insurance dividends. If you own a permanent, cash-value building life insurance policy from a mutual company (that is, a company owned collectively by policy-holders, rather than by stockholders), and your policy generates dividends that are credited to the cash value of the policy in the form of paid-up life insurance (increasing your death benefit), the IRS considers life insurance dividends to be a return of an overpayment of premium to you – and therefore not taxable.
- Life insurance cash value. Whether your permanent life insurance policy is with a mutual company or not, any increase in your life insurance cash value is tax-free, and you can borrow against your eventual death benefit – essentially drawing down that cash value – free of federal income tax, provided you structure the transaction as a loan. You may choose to pay back the loan, with interest, or let interest accrue and let the death benefit pay it off.
The combination of accruing cash values and the dividends on participating life insurance policies essentially creates an alternative Roth IRA account – minus the $5,500 per year restriction, and minus the restrictions on early withdrawals.
4. Take Dividends, Not Income
People who own and operate their own corporations try to take as much of their compensation as possible in the form of dividends, rather than as salary. Why? Salary is taxable as income – and you have to pay Social Security and Medicare taxes on it. But there’s no OASDI tax or Hospital Insurance tax due on dividend income like there is on W-2 income. That saves 15.3 percent right there, when you include both the employer and employee portion of Social Security and Medicare tax.
Dividend income also gets a preferred tax rate. If you earn over $400,000, your dividends get taxed at 20 percent in 2013. For everyone else, your dividends are subject to a 15 percent dividend income tax.
Note that the Internal Revenue Service is wise to this, too. So you don’t get to try to characterize your whole paycheck as dividends. If you own and operate your own corporation, you must pay yourself a salary that is “reasonable,” or you run into trouble with the IRS.
Note that there is a new 3.8 percent tax on investment income, thanks to the Affordable Care Act, that does potentially affect dividend income. It’s called the Net Investment Income Tax. You are subject to this tax if you are single with a modified adjusted gross income of over $250,000 if you are married, $200,000 if you are single, or $125,000 in you are married filing separately. See Joanna Pratt’s story here for details.
Per the IRS, the Net Investment Income Tax will apply to earnings from “interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of IRC section 469). To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income.” The tax will also apply to capital gains from the sale of stocks, bonds and mutual funds, as well as investment real estate and 2nd homes that are not your primary residence.
5. Understand Your Life Insurance Strategy
For this strategy to work, you should have some significant free cash flow to squirrel away into a whole life or universal life insurance policy. The trick: Set a relatively small permanent death benefit, and cram as much premium into it each year as you can, and let it grow. The low permanent death benefit keeps the cost of insurance down. Everything extra you throw at it over and above the cost of insurance (that is, mortality and expenses) accumulates tax free, and can be used for anything you like. If you like the tax treatment of a Roth IRA, and you want more money exposed to this kind of tax treatment, or you want to hedge your exposure to the risk of future income tax hikes, this might be an appropriate strategy for you.
The downsides: Life insurance is a front-loaded financial product. Most of your first-years’ premium goes to paying your agent, his boss, the underwriter, and admin expenses like your medical exam. So expect your policy to be “underwater” for a while. Usually these plans need to “cook” for about 7 to 15 years to really work well. Also, you want to make sure that your stream of income is pretty stable for the early years of the policy. You don’t want to be forced to lapse them because you can’t pay the premium (though the cash value provides a nice cushion to help you pay premiums in later years of the policy).
- Tip: Life insurance cash value doesn’t count against you for the purposes of calculating need-based financial aid eligibility under the federal system. This makes these policies a popular option for upper middle class to affluent families seeking to accumulate money for college.
6. Sell Losers Along With Winners
If you own assets outside of a retirement account and you sell at a profit, you must pay capital gains taxes on any gains. The tax deal for 2013 actually increased the max capital gains tax from 15 percent to 20 percent, so this just became more important.
But this is where diversification comes in: The IRS only assesses tax on the difference between gains and losses. If you own many different kinds of assets – some that zig while others zag – you may well have some losers that you can sell, too. When you do this, you cancel out your capital gains tax – and up to $3,000 per year in ordinary income.
7. Use Index Funds and ETFs
In addition to the benefits of rock-bottom expense ratios, index funds and their ETF cousins just don’t tend to do much internal trading either. Once a stock or bond enters the index, it usually stays in the index. This means that there are fewer issues with nasty capital gains distributions to shareholders in taxable accounts. Index funds and ETFs are generally more tax-efficient then actively managed funds, which may turn their entire portfolio over every year.
8. Consider Owning Real Estate
Don’t pay too much mind to the nasty real estate losses we experienced in 2007-2009: from which we are still recovering. That clobbered many investors, but the smart money ignored it. Real estate allows for indefinite deferral on capital gains, which are leveraged – by tax-deductible debt – at near record low interest rates. Meanwhile, real estate investors are reducing their tax burden further by taking allowable deductions for depreciation. Rental income is taxable, yes – but largely offset by other deductions and expenses. Meanwhile, you can defer capital gains indefinitely through use of 1031 exchanges.
- Remember who writes the tax code: Almost all are property owners. Real estate is still a powerful and tax-efficient long-term generator of both wealth and income.
There are more tax reduction techniques and opportunities that the wealthy pursue, such as carrying forward net operating losses from year to year, debt-financing, options, intentionally-defective grantor trusts, and others that apply more to specific situations. Some of them have asset-protection ramifications, too. But hopefully these tips can help you get started in learning how to optimize your taxes.
Additional Tax Resources:
- NerdWallet’s Top Tax Tips for 2013 From the Experts
- NerdWallet’s Tax Season 2013 Roundup
- NerdWallet’s Turbotax vs. H&R Block Cost Comparison Study
- What is Tax Freedom Day and When Will it Fall in 2013?
Tax image courtesy of Shutterstock.