The US has a progressive tax structure; the more you make, the higher your taxes are.
So, does it imply that the wealthy pay the most in taxes?
Not necessarily, as the tax code has certain loopholes that the rich exploit to lower their income taxes. As a CPA, one of the most frequently asked questions I come across is how people can cut their tax bill or how rich do their tax-planning.
This post will take into account some of the best tax-saving strategies wealthy individuals use to limit their taxable income.
Equity investments are a tested method of generating long-term returns.
Research reveals that 52% of American households invest in stock markets. However, the percentage of equity investments held by higher-income families is much higher than lower-income families.
|Family income||Percentage holding stock investments|
|$35,000 to $52,999||44%|
|$53,000 to $99,999||66%|
Source: Pew Research
Why is it so?
Because of the enormous difference in the tax treatment of capital gains and ordinary income that lower-income groups are unaware of.
Capital gains attract tax rates of 0%, 15%, and 20%, whereas taxes on employment income varies between 10% and 37%. As a result, when wealthy investors sell their investments, they pay far lower taxes on capital gains than what average investors pay on earned income.
- The taxation rates are lower on capital gains.
- Equity investments have historically outperformed fixed-income products.
- Equity investments have a higher risk profile. They are suitable for investors with greater risk tolerance.
Most people are aware of retirement plans, including IRAs, Roth IRAs, and 401ks.
While these retirement plans offer modest contribution limits (up to $26,000), there are some underestimated retirement plans that allow you to contribute up to $200,000 annually.
The combination of a defined benefit plan and a defined contribution plan (401k) can help business owners contribute up to $250,000 to their retirement plan. As surprising as it may sound, wealthy investors use these retirement structures to their benefit.
Defined-benefit plans differ from defined contribution plans in a way that the former guarantees net benefits, and the employer is responsible for making contributions, investments, and fund management.
Defined-benefit plans calculate contributions using multiple factors, such as income, length of employment, and age. The contribution limits for defined benefits plans are between $100,000 and $250,000 or more in some cases.
In addition to a defined benefit plan, business owners can set up a 401k plan, which allows them to make additional employee deferral contributions of up to $26,000 along with profit-sharing contributions.
- Employers can contribute up to $250,000 in pre-tax dollars to a qualified retirement plan.
- DB and DC plan combinations should satisfy nondiscrimination rules set forth by the IRS.
- These retirement accounts require annual maintenance, but their benefits outweigh these maintenance charges.
The IRS treats employment income and business income differently.
As a salaried employee, you can claim standard deductions of up to $12,400 (2020) and $12,550 (2021).
On the contrary, as a business, you can claim your travel expenses, home office rent, supplies, internet, phone, and any money you spend on your business.
It does mean that you have to register yourself as a sole proprietor, LLC, or partnership to claim business income deductions.
The standard deduction for qualified business income is 20%, depending on your trade and income levels.
- You can claim business expenses as deductions, up to 20% of your business income (depending on your income levels).
- Incorporating a business involves accounting, incorporation expenses, but the deductions make it worth it.
4. Life-insurance borrowing
Insurance should be a part of your financial planning. In fact, most advisors recommend investors to purchase term insurance or whole life insurance for death protection or similar casualties.
The average investors purchase term life insurance, but the wealthy invest in whole life insurance or universal life insurance policy for its hidden tax benefits.
Here is how it works:
A whole life insurance policy comprises two components: death benefit or face value and cash value. A portion of the premium is reserved for providing the death benefit, and the remaining amount goes towards the cash value of the policy.
The policyholder can borrow against this cash value. This loan doesn’t come under regular income, which means no income taxes, and there are no eligibility requirements for this loan. The insurer can repay this loan in accordance with a pre-defined tenure.
There are no limitations on how you can use these funds.
- You can have access to tax-free money with no limitations on how you can spend it.
- The premiums can be slightly higher for average investors.
5. Use depreciation to lower taxes.
Depreciation is one of the handiest strategies when it comes to lowering your taxable income.
The IRS defines depreciation as:
“Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration or obsolescence of the property.”
The best part about depreciation is that you can use it for both tangible assets (vehicles, furniture, buildings, machinery) as well as intangible assets (patents, software).
Let’s take an example of real estate.
The useful life of a residential property stands at 27.5 years as per the IRS. If you purchase a rental property worth $400,000, you can claim $14,500 in annual depreciation or $1,200 per month.
In addition to the standard depreciation, you can claim depreciation on new appliances or other components of your house.
This allows you to lower your taxable rental income. The trick is to calculate depreciation in accordance with the IRS guidelines.
Similarly, you can use depreciation for your machinery (that Mac) or even a software product.
- You can lower your net taxable income using depreciation.
- Depreciation applies to both tangible and intangible assets.
- You must use the IRS guidelines for calculating depreciation to avoid any penalties.
Where the wealthy excels in comparison to average investors is their ability to pass down wealth to their future generations. They do it using multiple strategies, with estate and gift tax exclusion as one of the popular ones.
The recent changes in the Tax Cuts and Jobs Act allow exclusions of up to $11.18 million between 2018 and 2025. According to the current rules, these limits will revert to $5.49 million after 2025.
Here is how it works:
- Individuals can set up a trust or estate plan for their future generations.
- Under the new rules, they can transfer over $11 million as gift or death benefits to this trust.
- These transfers are not subject to 40% income tax.
- You can transfer up to $11 million as a gift or estate benefits to your future generations.
- You don’t have to pay income taxes on these transfers.
- The exclusion limits will revert to $5.49 million after 2025.
Most of the tax strategies we discussed in this post apply to wealthy, high-income individuals and regular salaried people. The trick is to plan ahead and implement these tax maneuvers for maximum gains.