We’ve all seen the numbers. High-income earners are subject to higher marginal rates these days: 39.6% on incomes over $400,000 for single taxpayers and $450,000 on couples filing jointly on their 2013 returns. Additionally, single taxpayers with incomes over $200,000 and married couples with incomes over $250,000 are now subject to a 3.8% “surtax” on their investment-related income as part of Patient Protection and Affordable Care Act, better known as Obamacare.
Yet few wealthy taxpayers pay anything close to those percentages. Data for the past two tax years is not available yet, but in tax year 2010, the top 0.1% of taxpayers — those with incomes of more than $1.6 million per year — had effective tax rates of less than 23%. That’s far below headline top marginal rate of 35% that year.
So, how do the big boys do it?
Wealthier taxpayers will probably always have access to tax breaks that rank and file Americans will never enjoy. But today, we’re going to take a few tricks out of their playbook.
Most Americans have access to some form of retirement plan, be it a 401k, a 403k or a 457 plan. In 2013 and 2014, the contribution limits on these sorts of plans is $17,500, or $23,000 for employees aged 50 or older.
Yet self-employed taxpayers — and most wealthy taxpayers fall into that category — can contribute significantly more. The contribution limits on two popular options — SEP-IRAs and Solo 401ks — are $51,000 in 2013 and $52,000 in 2014.
Is this something that an ordinary American can take advantage of? If you have any kind of side business or part-time contract work in addition to your regular W-2 day job, then yes.
But you have to make sure you utilize the right retirement plan option. At high income levels, SEP IRAs and Solo 401k plans offer identical tax savings. But at incomes lower than $204,000, there is a big difference. In a Solo 401k plan, you can contribute the first $51,000 you earned last year. Whereas with an SEP, your contribution is based on a formula: 25% of your compensation up to $51,000.
So, in a hypothetical case in which your side business earned exactly $51,000 in 2013, you could defer taxes on the total amount using a Solo 401k plan, but only $12,750 using an SEP IRA.
Step-Up of Cost Basis
Whenever a taxpayer dies, the cost basis of investment assets gets “stepped up” to the current market value. A wealthy investor could literally have millions — or billions — in unrealized capital gains that disappear at death, giving his or her heirs a clean tax slate. (Of course, estates larger than $5,340,000 in 2014 will be subject to the estate tax, but that is another topic for another article.)
Ordinary Americans inherit much smaller nest eggs, of course, but the same principles can be put to work with a portfolio of any size. If you are doing estate planning and have highly appreciated stock that you bought years or decades ago, consider holding on to it for the remainder of your life with the understanding that your kids or grandkids can sell it and reinvest the proceeds in a diversified portfolio.
I should give one important caveat here: Avoiding taxes should not be your primary investment consideration. If a single stock or small number of stocks makes up a disproportionately high percentage of your net worth, you might be taking too much risk. Avoiding a 15% to 20% long-term capital gains tax is great, but not if it comes at the risk of losing more than that in capital losses if the stock falls in value.
Every taxpayer will need to weigh the cost and benefit on a case-by-case basis.
Giving Gifts to Charity
Charitable giving is always going to be more beneficial to a high-income earner than to a regular American for two reasons:
- Most Americans take the standard deduction on their tax return, as their itemized expenses are not high enough to justify itemizing. The standard deduction in 2013 for a married couple filing jointly is $12,200.
- The charitable deduction reduces your tax burden at whatever your marginal tax rate is. The same $10,000 contribution will be worth $3,960 to the taxpayer in the 39.6% bracket but just $2,500 to the taxpayer in the 25% tax bracket.
Still, while this deduction is more beneficial to higher-income earners, that doesn’t mean it can’t be used to your advantage come tax time. If you like the idea of supporting a charity, church or even your old alma mater, you might as well get a tax break from it. Keep track of all cash donations you make as well as any clothes or other items you give. Cleaning out your closet of clothes you no longer wear can save you hundreds or maybe even thousands in taxes while also decluttering your house.
Regular Americans might never get to enjoy tax breaks to the extent that the wealthy do. But that’s OK. By following the same ideas, we can at least knock a few percentage points off of our effective tax rates — and every dollar saved in taxes is a dollar that can be spent on something you actually enjoy.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Check out his new premium service, Macro Trend Investor, which includes a free copy of his e-book, The New Megatrend Investor: The Ultimate Buy-and-Hold Strategy That Will Make You Rich.