Some wealthy people are able to pay taxes on a lower percentage of their incomes than the non-wealthy because the wealthy generate significant earnings from investments that are taxed at a lower rate than employment income. The non-wealthy get most of their income from employment.
The money you earn from a job is subject to federal and state income taxes. The more you earn, the higher the tax rate you pay on the last dollar you earn.
Regardless of how much you make, employment income is also subject to payroll taxes (FICA), which are currently 6.2% for Social Security and 1.45% for Medicare. Self-employed workers pay almost double those amounts since they have to pick up the employer’s share of the tax. Employees lose out on the higher wages and salaries their employers could have paid them if not for the additional tax.
Investment income is subject to different tax rates depending on the type of investment, how long it was owned and the investor’s marginal tax rate, but the rates are often substantially less than the rates on employment income. Here are some examples of the federal tax rates on different types of investment income:
Qualified dividends: 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else
Long-term capital gains: 0% for taxpayers in the 10% and 15% brackets; 15% for everyone else
Tax-exempt municipal bond interest: 0%
Also, while interest income from U.S. Treasuries is subject to federal income tax, it is exempt from state and local income taxes. This feature can help taxpayers in high-tax states and localities reduce their tax bills.
As you can see, investments are generally taxed at a lower rate than employment income. If you start building an investment portfolio, over time, your investment returns might generate a significant portion of your income, too. When they do, you’ll be glad that this income is taxed at a more favorable rate. (If you would like to learn more about investing, read Beginner’s Guide To Tax Efficient Investing.)
The Bottom Line
Many of the strategies that millionaires and billionaires use to reduce their taxes are perfectly legal and available to everyone, but taxpayers with modest incomes may not have the resources to take advantage of these techniques. Not everyone can afford to make large donations and retirement contributions or to hire sophisticated financial planners and tax accountants, but that doesn’t mean that the wealthy are tax criminals.
Additionally, the wealthy may be less afraid to take advantage of every possible deduction because they have the resources to defend themselves against an IRS audit, but again, that doesn’t make them tax evaders. Furthermore, tax evasion is not a crime of the super-rich. People at all income levels refuse to pay the taxes they owe, whether they do it by not filing a return, filing a fraudulent return or attempting to circumvent the tax code. These people usually get caught and have to pay up sooner or later. The rest of us could learn something about legal tax minimization strategies from those who employ them.