The American tax code is designed to collect higher taxes from higher-income households. With tax brackets ranging from 10% on the lowest income side to 37% for the richest, “higher-income Americans tend to face higher marginal tax rates and pay more federal income taxes,” says the nonprofit Tax Foundation.
So why do we hear about the rich paying less taxes?
To understand how millionaires typically reduce their taxes, it’s helpful to look at the strategies and advice they receive. These are some of the tax tricks that millionaires use to reduce their tax burden.
Read more: How billionaires get away with paying less income taxes
Savvy investors know about asset allocation: managing risk by utilizing a variety of investments that balance a portfolio for volatility and long-term returns.
Brian Schultz of Plante Moran Wealth Management says millionaires take asset allocation to another level: tax efficiency.
One strategy: Assets that generate the most cash flow are held in tax-deferred retirement accounts, such as IRAs and 401(k)s.
“They currently don’t pay taxes on the income, and then if they leave it to charities, they never pay taxes,” Schultz told Yahoo Finance. It also notes that lower balances in tax-deferred accounts can reduce required minimum distributions at age 73, triggering income taxes.
Meanwhile, high-growth investments are held in taxable accounts.
“If I have a portfolio of stocks or stock mutual funds in my taxable accounts, and I sell them to provide assets for my living expenses, I get capital gains rates on the growth. If I don’t spend the money and I don’t sell, I get a step-up in basis (at death), so the growth is never taxed,” he added.
Attorney and financial advisor, Sharon Winsmith of Winverse Online Financial Education, agrees.
“Do everything you can to avoid accumulating large balances within traditional 401(k) or IRA plans,” Winsmith said. “If you have large balances, I would suggest looking into doing backdoor Roth-IRA conversions to get as much money as possible from traditional 401(k)s and IRAs.”
For millionaires with large unrealized gains on taxable investments, evading taxes requires extra effort.
“Although capital gains tax rates are lower than ordinary income tax, taxes are still paid,” Schultz said. “One option available is for a client to be able to borrow against their assets to fund their lifestyle.”
For example, an investor with a $20 million stock portfolio who wants to spend $200,000 a year in retirement could use the assets as collateral for a loan. The investor borrows $200,000 at 7% interest. You could pay $14,000 in interest that year, but zero taxes.
“At the end of the year, I still have all my assets growing, but now I have a $200,000 line of credit against my investments. I had no income taxes because I didn’t have to sell anything, so I had no gains to recognize. And I had no taxable IRA distributions,” Schultz said.
The strategy is called Buy, Borrow, Die.
“This strategy allows you to pass on assets to your heirs without having to pay capital gains taxes on the appreciation of those assets. The strategy also forces you to be a disciplined investor by encouraging you to only purchase assets that you are willing to own for the long term, which helps you avoid making emotionally driven short-term investment decisions,” Winsmith added.
Read more: How are dividends taxed?
Wealthy investors also use trusts to reduce taxes. Some trusts can hold highly appreciated shares, without increasing costs for heirs. That could leave heirs with a huge capital gains tax bill.
Schultz said that in a grantor trust, the strategy known as substitutionary power can allow for a transfer of assets of equal value. By exchanging cash, bonds or other assets that are not highly appreciated, heirs can avoid a tax shock.
“So yes, my heirs won’t get a step-up in basis on those $5 million of assets, but there’s very little unrealized gain anyway,” Schultz said. “But I took that $5 million of stock that had grown over time into my estate. Now my heirs will get a full step-up in basis… and will help minimize the tax my family or heirs will pay.”
A tax trick that the rich are extremely adept at: reducing (or shifting) personal income to a less taxed bracket.
“Under current tax laws, I recommend looking for every possible opportunity to convert earned income into self-employment income or business income,” Winsmith said. “W-2 wage income is taxed at the highest rates and is the least efficient way to make money.”
He noted that many small and medium-sized businesses are willing to structure compensation so that you are treated as an independent contractor.
“This allows you to take advantage of tax deductions that would otherwise not be available to full-time employees, such as expense deductions, the qualified business income (QBI) deduction, and the home office deduction,” he added.
With federal estate tax exemptions now totaling $15 million ($30 million for married couples), if a wealthy person has two children and wants to leave them $5 million each, anything over that $10 million that is donated to charity is not taxable.
“That’s an efficient estate plan, it’s tax efficient,” Schultz said.
However, he says it’s actually more tax efficient to make charitable gifts during your lifetime.
“If they were willing to make some donations to charity while they were still alive, now you take those assets out of your estate and you also get an income tax deduction for making the charitable donation,” he added. “Honestly, a lot of times it’s kind of a mindset shift for customers when they think about it for the first time. They can see that some of their money is going to help support the causes they care about.”