During the last election cycle, Mitt Romney’s taxes received a considerable amount of attention and press coverage. Romney is an extremely wealthy individual who in 2011 earned around $14 million dollars. Yet his tax bill only came to a little less than $2 million in that year. That’s an effective tax rate of 14%, or about half of what the middle class is required to pay.
How do wealthy individuals like Mitt Romney pay so little in taxes, while the average middle class American pays 25% (or more, if self-employed)? There are several ways the rich can legally get away with paying less. They use creative strategies to minimize what they owe so they can make the most of their earnings in order to keep money it in their own pockets and away from Uncle Sam.
The good news is that with the right knowledge and some professional help on your side, you can appropriate some of those strategies from wealthy individuals to minimize your own tax bill even as an average taxpayer.
If You Have A Lower Income, You Pay Lower Income Tax
One of the main ways the wealthy pay less in taxes than everyone else is that they are not on a payroll. Their earnings come from a variety of investments. You can mimic this technique by putting a large portion of your income towards tax-friendly investments and then pay less in income taxes.
Consider saving the largest percentage of your income as you can, and using that savings to put into tax-deferred accounts like 401K plans, tax-except investments like municipal bonds, and deferred compensation plans if you have one available to you. This helps reduce the amount of money you’ve earned that can be taxed. By putting away a significant amount of your income in these accounts, you can put yourself in a lower income tax bracket to taxed at a lower rate.
There are also other, more complicated ways of manipulating different investments, which include using (but not selling) underwater stocks and utilizing different insurance products that combine a death benefit with investments, the returns of which are tax-free.
A trusted tax professional can help find the best tax shelter options for you. Another way the wealthy take advantage of the tax system is by knowing how it operates. Unless the IRS or a court has ruled a specific action illegal, taxpayers are free to interpret the current codes as they see fit. By having a professional on your side, you’re more likely to maximize the savings on your tax bill because they’ll know how to be creative in establishing effective tax shelters.
How Capital Gains Can Increase Your Wealth (but Not Your Tax Bill)
If you have investments that earn returns, these are considered capital gains – not income. This is advantageous because the current tax system established by the IRS taxes this money at a lower rate than traditional income. Additionally, if your investments increase in value but you don’t sell those assets, you’re not taxed on the added value of the investment. Instead of selling portions of your portfolio – and then paying taxes on your earnings – make like the wealthy and simply borrow against the value.
Make the Most of Your Investments
If you need another reason to have a CPA on your side, let’s return to the example of Mitt Romney. He has been able to earn incredible returns within his tax-deferred traditional Individual Retirement Account – or IRA – that are so high they might seem like impossibilities to the average investor and taxpayer.
That’s because wealthy individuals like Romney also invest in smart, talented accountants to help them grow their money as quickly as possible while simultaneously working on a plan to make that financial growth tax-deferred or completely tax-free.