While recent reporting may make it seem that all “rich” people are able to avoid paying taxes, I assure you there are plenty of high-income and high-net-worth people who feel like they are getting kicked in the nuts with substantial tax bills. There is a reason my phone blows up every year around tax season with people looking for expert tax planning guidance beyond what they are getting from their current financial professionals. Depending on how you earn your money, some of the tax planning strategies mentioned in this post may be available to you. Some may be cost-prohibitive and time-consuming to implement for those without multi-million-dollar incomes or multi-million-dollar investment portfolios.
In case you were wondering, different types of income are treated differently by the IRS. Whether you earn a paycheck, are self-employed (or a business owner), make money from investments (short-term or long-term), receive equity compensation (stock options, ISO, RSU etc.) or even retirement income like an annuity, Social Security, pension, or withdrawals from a 401(k) – each of your income streams may be subject to different tax rules and regulations. Lastly, we have a progressive tax system, so theoretically, the more you make, the higher your tax rate should be.
As you have likely seen in the news lately, many of the wealthiest Americans have founds ways to be proactive with tax planning and financial planning to minimize the taxes they owed. In many cases, they have eliminated their federal income taxes. It was reported that billionaire Elon Musk was able to get his income down far enough to qualify for a $4,000 child tax credit. I appeared on Nightline a few years back to discuss how Donald Trump was able to pay just $750 in taxes. When looking at the wealthiest Americans listed in the ProPublica reporting avoided income taxes, it sounds like he may have gotten ripped off. In comparison, many of the strategies he used to skip out on paying the IRS are out of reach for the average American. Some of the tax minimizing techniques used by the other billionaires (think plutocrats like Bill Gates, Elon Musk, Warren Buffett or the Walton family) are more obtainable for the merely high-income and/or high-net-worth Americans.
“The shock stems, in part, from a disturbing reality: Nowhere does ProPublica assert that these men cheated, lied, or did anything felonious to lower their tax burdens. The naked fact of the matter is that not even one of the documented methods and practices that allowed these billionaires to so radically minimize their tax obligations was illegal.” – Abigail Disney via the Atlantic
Taxes Will Be Going Up, Making Tax Planning Guidance Even More Valuable
It isn’t what you make but what you keep. Taxes are about as low as they have ever been (even though it may not feel that way when you pay them), they will likely be higher in the future. The desire of those with high incomes to minimize their taxes is growing, leading to a whole new generation of financial planners who go beyond just investment advice and help their clients minimize taxes along the way. Wealthy families have become savvier and are looking beyond flashy short-term investment returns and looking at their entire picture. This likely means looking at their total after-tax return on investments and the growth of their net worth, as well as looking for guidance to live a healthier, happier, and wealthier life today and into the future.
President Biden has proposed some major tax increases that could dramatically change the wealth management plans for the wealthiest Americans. To be clear, “wealthiest” likely refers to those who are around the top 20-to-30% or so of income earners. Beyond the President, there is a sentiment of “tax the rich” coursing through society. At the same time, we have a ballooning national debt, as well as many baby boomers who are unprepared to replace their pre-retirement incomes once they leave the workforce.
Some of the proposals include extending the payroll tax for Social Security beyond the current cap of $148,800, increasing the capital gains rates paid on investments, and eliminating the step-up in bases at death for appreciated assets like stocks or real estate. We could also see changes to the size of an estate subject to estate taxes in the future.
Astute wealthy families are asking more of their financial advisors / financial planners/wealth managers. The days of pitching exotic or exclusive investments (with high commission or fees) are waning. Investment options in many respects are commoditized. In contrast, expert financial guidance is the value a great financial professional can bring to the table. This typically included a more holistic approach to help the families minimize taxes, improve their investment choices, and address estate planning needs. Not to mention sometimes playing the role of financial therapist, finding ways to reduce financial stress, and just help them live a happier, healthier and even wealthier life.
Tax Mitigation Strategies for the High Net Worth
Potential tax increases have been all over the news, which has prompted many wealthy families in the US to seek out better tax mitigation guidance. Don’t get me wrong, taxes have always been a significant concern of the rich, but the proposed tax hikes have made this topic a more immediate problem to be addressed, not to mention, they could really upend the current strategies that many families and business owners employ today.
Business owners have a lot of discretion when it comes to some of the taxes they pay. Setting up a Defined Benefit Plan could allow many of them to lower their taxable income substantially each year. Many of the clients I have worked with on Cash Balance Pension Plans had never heard of them. To be frank, I’m shocked their previous wealth managers had never mentioned them. I’m currently working on a plan - where a client will be able to shelter nearly one million dollars in income, per year, across his family members who work in the business. The money used to fund the plan has just been sitting in the bank, earning literally nothing in interest.
Eliminating Taxes on Investment Gains
Would you believe many millionaires and billionaires are able to pay little to no taxes on the growth of their taxable investment portfolios? Getting hit with a capital gains bill is never fun, but smart tax planning can help keep taxes on your investments to a minimum or even eliminate them completely.
At the highest level, there are four common ways to not owe any taxes on your investment gains. First, keep investments inside of tax-advantaged accounts like a 401(k), IRA or Roth IRA. Taxes will eventually be due here when you make a withdrawal. Income limitations can also limit the benefits here to the wealthiest Americans. The second way is tax-efficient investing. Being a bit wiser with your buying and selling can help you realize fewer capital gains, or at least avoid realizing short-term capital gains, which are taxed as regular income. This is tax-loss harvesting, which I will discuss further down in this post. The fourth way has been described as invest-borrow-die, which is a strategy often used by families with dynastic wealth or even newer multi-millionaires and billionaires.
Essentially the invest-borrow-die strategy can translate into unlimited investment gains with no capital gains or income taxes ever coming due. You buy investments (or start a company or business) and never sell the holdings. To be able to utilize the value of your investments, you borrow against them, generating a tax deduction for the interest paid. (This interest deduction can help offset gains you may have realized in your portfolio). Eventually, you die receiving a step-up in cost basis for your investment gains. The step-up in basis means your heirs can sell the holding (if they choose to) and not owe any capital gains taxes. As a tax-planning financial planner, I will point out that if you have a substantial net worth, you will need to also minimize or eliminate estate taxes.
When tax-loss harvesting, we are selling certain shares of an investment at a loss to reduce taxes on the investment portfolio at the end of the year. You can use up to $3,000 of short-term losses to offset regular income. If you are selling an investment with a long-term capital loss, those losses can help offset the capital gains from other investments that have been sold for a profit. Tax-loss harvesting can help wealthier investors rebalance or reposition some of their assets while minimizing taxes along the way.
We are just highlighting a few tax strategies that help billionaires pay little to no taxes. These are strategies you can likely employ as well to help reduce your tax liabilities today. Other strategies used by the wealthiest Americans would bore you to death if I tried to explain them in any detail. Some are just too costly, cumbersome, and complicated to implement unless you have millions upon millions of dollars of income to minimize taxes. Regardless of where you fall on the net worth and income scale, be proactive by taking steps to reach your financial goals and legally pay the least amount of taxes along the way.
This article originally appeared on Forbes.
