Have you ever wondered how the rich can earn so much money and pay so little in taxes? It may seem unfair. Warren Buffett, for instance, has openly said that he pays a lower tax rate than his secretary. The rich have quietly kept the secret to themselves. The secret is out now, and here is how you too may be able to use the tax reduction strategies of the very rich.
The wealthiest 400 people in the United States only pay taxes at an average rate of 8.2 percent, according to a 2021 report. The average American, however, pays a higher tax rate.
The secret is based on the type of income the rich receive, compared to how the not-so-rich receive their income.
The average working person gets a regular paycheck and pays taxes each time. The rich, however, often do not receive a regular income. Their income mostly comes from stocks and other investments. They do not benefit from the income their investments produce until they are sold. This is called unrealized capital gains.
The U.S. tax code was aimed at the working man and those with a regular salary. The system enables the very rich to owe a lower tax rate than many Americans.
The rich have learned how to reduce taxable income—enabling them to leverage money for the greatest gain. They also know how to use money in ways to avoid capital gains tax.
Short and Long-term Capital Gains
The IRS only charges taxes on the interest you earn on an investment after it is sold. A capital gain occurs when the price you sell an asset for is more than your original cost—the basis. Generally, you will pay fewer federal taxes if you hold the asset for more than one year. You will pay long-term capital gains tax, as opposed to short-term capital gains tax, which you will incur if you sell less than one year after purchase.
An example of how the rich might use their assets to earn money while avoiding capital gains tax is as follows. You bought $500,000 in stock. The stock grows and you end up having $1,000,000 in stock. You will not pay a dime of tax on that extra $500,000 you earned—until you sell the stock. Therefore you can hold on to that stock until it is most advantageous, tax-wise, to sell.
Long-term Capital Gains Ceiling, Tax Savings
Federal income tax has a ceiling tax rate of 37 percent. That is the maximum amount of how much you will pay in income taxes if you have a job. However, the maximum amount you will pay for income from long-term capital gains is 20 percent—about half the rate of income taxes.
There are exceptions. For instance, some assets, such as income from rental real estate, antiques, art, stamps, and collectibles, carry a higher maximum capital gains tax, which could go as high as 28 percent.
The takeaway here is that depending on the value of your assets, you will end up owing less in taxes under capital gains tax rates than you would under income tax rates.
It’s important to note that profit from some types of property may not be considered capital gains but taxed as ordinary income. This may include a product you sell (classified as inventory) or intellectual property that the creator holds, such as a patent, a secret formula, music, or literary compositions.
Or You May Want to Avoid Capital Gains …
There are other situations that may require paying a capital gains tax. These situations could include property over which you give exclusive use rights to another party, an exchange of property, or property taken over by the government.
To avoid capital gains taxes, some real estate investors will refinance their properties instead of selling them.
If you have lived in your principal residence for at least two of the last five years, you may not need to count the profit as capital gains if you sell. Singles can exclude up to $250,000 of that profit, while those who are married and filing jointly can exclude up to $500,000.
Calculating capital gains tax
Capital gains earned in one year or less are called short-term capital gains. These gains are reported as ordinary income and are taxed accordingly, at rates up to 37 percent.
Depending on your tax filing status, you can avoid long-term capital gains. In 2022, people who are single or married filing separately can have income up to $41,675 without owing any taxes on capital gains. A head of household can earn up to $55,800 without paying taxes on those gains, and a married couple filing jointly can earn up to $83,350 without having a tax debt on it.
Earning more than the amounts above could bring an interest rate of 15 percent. Singles in this category can earn up to $459,750, and those married filing separately can earn up to $258,600. A head of household can earn up to $488,500, and someone married filing jointly can earn up to $517,200.
Those earning above these amounts will be subject to a 20 percent capital gains tax. And that is where the really rich start to really save money on taxes.
You can calculate your capital gains tax by first adding up your costs related to the asset. Real estate, for instance, includes the cost of the property, inspections, agent commissions, closing costs, maintenance, insurance, repairs, and taxes. Then subtract this amount from the sale price and the difference is either your capital gains (if more than the total cost) or your capital loss (if less than your cost).
Before you estimate your capital gains tax, make sure you have all your figures for calculating your basis. It will reduce your taxes more.
Donating Stock Avoids Capital Gains Tax
Another thing that the rich do to avoid capital gains tax is to give away stock. Instead of selling your stock and then giving the balance away, donating it directly enables you to give up to 20 percent more (depending on its value)—which is the maximum amount of taxes you will pay for capital gains. You benefit even more because you can deduct the full amount of your gift from your taxes and there are no capital gains taxes on that amount.
The Net Investment Income Tax
Besides the capital gains tax, some people may need to pay an additional 3.8 percent more for a Net Investment Income Tax. This tax is based on your modified adjusted gross income (MAGI), according to the following schedule:
- $250,000 if you are married filing jointly or are a qualifying widow(er) with a child
- $200,000 if you are single or the head of household
- $125,000 if you are married and filing separately
Loss Limits for Deductions
The IRS states that if you have a capital gains loss, you can only deduct up to $3,000 or the actual amount—whichever is less. If the loss is greater than $3,000, it can be carried over to future years.
A loss over the $3,000 limit can lower any gain in future years. You can use it at a rate of $3,000 per year—or until there is no more left.
Invest in tax-deferred retirement plans
One way to escape capital gains tax is to put some of your money into retirement plans that let your money become tax-deferred. Depending on your plan, you will not owe taxes until you withdraw the money. If you wait until retirement to start withdrawing it, you will be in a lower tax bracket and pay fewer taxes.
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