The US tax code is designed to collect higher taxes on households with higher incomes. With tax brackets ranging from 10% on the low-income side to 37% on the richest, “high-income Americans tend to face the lowest tax rates and pay federal income taxes,” says the nonprofit Tax Foundation.
So, why do we hear about the rich paying less tax?
To understand how millionaires tend to minimize their taxes, it helps 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 know about asset allocation: managing risk by using a variety of investments that balances portfolio volatility and long-term returns.
Brian Schultz with Plante Moran Wealth Management says billionaires are taking asset allocation to another level: tax efficiency.
One strategy: High-cash-flow generating assets are parked in tax-deferred retirement accounts, such as IRAs and 401(k)s.
“Right now they’re not taxed on their income, and if they leave it in the organization, they’re never taxed,” Schultz told Yahoo Finance. He also notes that lower balances in tax-deferred accounts can reduce required minimum distributions at age 73, which results in income taxes.
Meanwhile, high-quality investments are held in taxable accounts.
“If I have a portfolio of stocks or stock mutual funds in my taxable accounts, and I sell those to fund my living expenses, I get capital gains rates. If I don’t spend and I don’t sell, I get a step up. [at death]so growth is not taxed,” he added.
Attorney and financial advisor, Sharon Winsmith of Winverse online financial education, agrees.
“Do everything possible to avoid accumulating large balances within 401(k) plans or traditional IRAs,” says Winsmith. “If you have large balances, I would suggest looking into doing a later Roth-IRA conversion to get as much money out of traditional 401(k) and IRA plans as possible.”
For millionaires with large unrealized gains on taxable investments, avoiding taxes requires more effort.
“Even though the capital gains tax rate is lower than the regular tax, you still pay tax,” Schultz said. “The option available is for the customer to borrow against their property 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 property as collateral for a loan. An investor borrows $200,000 at 7% interest. He might pay $14,000 in interest that year – but zero tax.
“At the end of the year, I still have all my assets growing, but now I have $200,000 of debt against my investments. I had no income taxes because I didn’t have to sell anything — so I had no realizable gains. And I had no taxable IRA distributions,” Schultz said.
The strategy is called Buy, Borrow, Die.
“This strategy allows you to pass assets down to your heirs without ever having to pay capital gains taxes on those assets. This strategy also forces you to be a more objective investor by encouraging you to only buy assets you intend to hold for the long term, helping you avoid making short-term, emotionally driven investment decisions,” said Winsmith.
Read more: How are dividends taxed?
Wealthy investors also use trusts to reduce taxes. Some trusts may have stock that appreciates – without increasing the cost basis of the beneficiaries. That can leave heirs with a huge capital gains tax bill.
Schultz said that in a grantor trust, a technique known as a power of substitution can allow for the transfer of assets of equal value. By exchanging for cash, bonds, or other assets that do not appreciate much, heirs can avoid the tax shock.
“So, my heirs won’t get a step up on that $5 million in assets, but there’s a very small benefit that’s not realized,” Schultz said. “But I pulled that $5 million that had grown 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 wealthy are very clever at: reducing – or shifting – personal income to a lower tax bracket.
“Under the current tax laws, I recommend looking at every opportunity to convert income into self-employment or business income,” said Winsmith. “W-2 income is taxed at higher rates and is a less expensive way to make money.”
He noted that many small to medium-sized companies are willing to arrange compensation for you to be considered an independent contractor.
“This allows you to take advantage of other tax deductions not available to full-time employees, such as expense deductions, Qualified Business Income (QBI) deductions, and home office deductions,” he added.
Since the federal estate tax exemption is now $15 million ($30 million for married couples), if a wealthy person has two children and wants to leave each of them $5 million, anything over that $10 million donated to charity is tax-free.
“This is a viable, tax-efficient housing program,” Schultz said.
However, he says it is more tax efficient to make charitable contributions during your lifetime.
“If they were willing to make certain donations to help the needy while they were still alive, now you receive those assets from your inheritance, and you also get income tax deductions for making the donation,” he added. “In fact, a lot of times it’s a mindset change for customers when they first think about it. They see some of their money go to work to help support those causes they care about.”
