Income Tax can quickly become extremely expensive for the 1% in the United States. Those earning over $523,600 per annum are required to pay $157,804 in tax and 37% of the difference between $523,600 and their annual salary. This is an incredible amount of money that, understandably, the richest do not want to pay.
In order to preserve as much of their annual salary as possible, the 1% use the following strategies in order to reduce the amount they are required to pay in tax while protecting their assets at the same time.
1. Holding Company
A holding company is a business entity created purely for the sake of owning other companies. In other words, it is designed specifically to supervise the subsidiaries it owns (and their assets) without engaging in their daily functioning. The intention of this is to limit the liability of one business’s debts to that business alone, rather than permitting liability for them to spread to another business owned by the same person.
In order to benefit from this liability protection, holding companies can be established as corporations or limited liability companies (LLCs) since both of these business entities inherently offer this liability protection as a default. While it is true that a corporation can, technically, be used it is more common for holding companies to be established as LLCs.
This is because LLCs have far fewer annual record-keeping and reporting requirements than corporations, which can noticeably cut the cost and hassle associated with the holding company. Additionally, LLC holding companies can be entitled to even fewer taxes (as a result of the nature of an LLC).
2. Municipal Bonds
A bond is a promise by a borrower to repay the lender in full with interest. Municipal bonds are offered by the government in exchange for a regular interest repayment over a stipulated time period.
The time period is dependent on the bond’s “maturity date”, which describes the point at which the buyer of the bond will have been fully repaid.
Since no federal taxes are charged on the interest of these government-issued bonds, the 1% are attracted to investing in them due to their tax-free interest repayments. This is why they are so popular among the 1% despite corporate bonds offering much higher interest rates.
3. Retirement Plan
The rich take advantage of their employee benefits and retirement accounts in order to receive tax breaks. Specifically, as of this year, up to $20,500 of a person’s annual income can be contributed to a 401(k) without being taxed. This method can be used to preserve this income for later while potentially dropping a person below the next tax threshold down.
Citizens over the age of 50 are also able to add an additional $6,500 on top of the standard retirement plan contribution in order to further shrink the amount of their income that is eligible to be taxed.
4. Health Savings Account
Workers who also have an HDHP (high-deductible health insurance plan) are able to take advantage of a health savings account to reduce their tax liabilities. In a manner analogous to a 401(k), HSA owners are entitled to make contributions to their account directly from their paycheck in order to exclude that money from being taxable.
Individuals can put in a maximum deductible of $3,600 a year, though this can also be matched by the employer to double the amount. A fringe benefit of this is that this HSA money used to pay for medical expenses cannot be taxed.
5. Establish A Business
Many of the 1% own one or several businesses. While these do provide them with streams of additional income, there are also tax-reducing benefits associated with their use. Moreover, certain expenditures encountered through the standard operation of the business can be subtracted from the owner’s total taxable income.
In specific scenarios, where the business owner works from home, they can take advantage of the home office deduction to subtract some of the costs associated with the home itself. Though businesses must be careful to do so while staying comfortably in line with the IRS’s guidelines.
6. IRS Tax Credits
There are a plethora of credits that shrink taxes offered by the IRS for individuals to claim; one of these is the Earned Income Tax Credit. While these are typically used by low and medium-income taxpayers to reduce their taxable income (e.g. the Earned Income allows reductions up to $6,728), they can still be utilized by the wealthier among us.
One example of this is Jeff Bezos, who was able to receive a $4,000 child tax credit in 2011 despite being worth $18 billion at the time. Between the years 2007-2011, Bezos paid no federal income taxes because he reported net losses on his investments. As such, his income was low enough that he could qualify for tax credits for all his children.
7. Long-Run Capital Gains
Last, but by no means least (quite the opposite in fact), is the way in which the wealthy use investing in order to further grow their wealth. In addition to the standard returns from investment, these financial instruments can be used in order to lower tax liabilities as long-term capital gains tax is extremely favorable.
While a capital asset that is owned for less than a year is taxed according to the normal income rates, where it is owned for longer periods of time than this the investor is only liable to pay 0%, 15%, or 20% on the capital gain hinging on their level of income. Understanding this difference in long and short-term capital gains is the crux to building wealth.
Investors can even cancel out their liability for capital gains tax through a technique called tax-loss harvesting. This process involves selling securities at a loss in order to nullify the capital gains tax they would be liable for on the sale of another security that would make money.
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