Erin wrote in with a wonderful question that I started to address in Monday’s reader mailbag, but the answer quickly escalated into many, many paragraphs. Here’s her question:
I don’t understand how billionaires who bring in millions a year can pay less in taxes than someone working hard at a job and making $50K a year. That seems really wrong to me.
She’s referring to statements like this one from Warren Buffett:
But the differential between me and the rest of the office, not just my secretary but the rest of the office, was greater than that. It’ll be closer, but I’ll probably be the lowest paying taxpayer in the office.
He’s not lying. It is very likely that Warren Buffett is paying a lower tax rate than the other people in his office.
How is that possible? Well, let’s dig in a little bit and find out.
Tax Rate and Your Tax Bill
Most of the time, when someone refers to how a rich person pays low taxes, what they’re actually referring to is the percentage of their income that they pay in income taxes.
For example, let’s say that Millionaire Joe makes $2,000,000 a year and his income tax rate is 18%. That means he’s paying $360,000 a year in income taxes.
On the other hand, Ordinary Guy Bill makes $50,000 a year, but his income tax rate is 20%. That means he’s paying $10,000 in income taxes.
Millionaire Joe is indeed paying a lower tax rate than Ordinary Guy Bill, but his tax bill is way higher than Ordinary Guy Bill.
Simply having a lower tax rate doesn’t mean that your total tax bill is lower. Your tax rate matters in terms of your tax bill, but so does your annual income.
When anyone earns income from their job, they pay the normal income tax rates, which are summed up in this useful article.
For example, a single person who earns $50,000 a year will have a total tax bill of $5,819. That means their overall tax rate will be about 11.6%.
On the other hand, a single person who earns $300,000 a year will have a total tax bill of $80,904. That means their overall tax rate will be 27%.
(I used this income tax calculator for the tax bill, then used division to get the overall tax rates.)
As your normal income goes up, so does your overall “effective” tax rate. That’s how most people expect that income tax works and that’s why it’s so surprising when it doesn’t seem to work that way.
Where things get crazy is when you start considering investment income. From that same article above:
A top rate of 15% applies to qualified dividends and the sale of most appreciated assets held over one year (28% for collectibles and 25% for depreciation recapture) for single filers with taxable income up to $406,750 ($457,600 for married filing jointly). Long-term capital gains or qualified dividend income over that threshold are now taxed at a rate of 20%.
So, let’s take another look at those income levels above.
Let’s say that someone has chosen a path of early retirement. They’re choosing to live on their investments and so all of their income during the year is from dividends on stock investments that they made years ago. This means that the dividends are considered “qualified dividends” and they qualify for a lower tax rate.
If this person makes $50,000 a year from these dividends and nothing from any other income source, when that person files their taxes, they’re only going to owe $443 in income taxes. Yes. That’s it. Their effective tax rate is less than 1%. (I used this calculator, filing single, with the default settings, $0 in regular income, and $50,000 in qualified dividends.)
Compare that to the tax rate calculated above. A single person earning $50,000 in normal income will pay $5,819 in federal income taxes, an 11.6% rate. A single person earning $50,000 in qualified dividend income will pay only $443 in income taxes, a 0.9% rate.
Wow. That’s huge. It gives us a great hint as to how rich people are able to keep their tax rates low.
What about that $300,000 person? If that person earns $300,000 this year in qualified dividends and $0 in normal income, that person will pay $37,943 in federal income tax. That’s a 12.6% rate. The person earning $300,000 a year in normal income, as noted above, will pay $80,904 in taxes. That’s a 27% tax rate.
Again, that’s really dramatic. That’s a difference of more than $40,000 a year in taxes paid in this example and it’s a huge clue as to how the wealthy keep their income taxes low.
Wealthy People Usually Earn a Mix
Most of the time, wealthy people have a total income that represents a mix of these different types of income. Here are a few typical examples.
A person who launches a startup company that eventually goes public is probably the CEO of the company. He might earn a salary of… let’s say, $500,000. A person in that situation usually owns a ton of shares of that company. Let’s say that person owns 10 million shares of their startup. Since they’ve never sold any of those shares, they’ve never paid any taxes on those shares. The company then pays a dividend of $0.25 per share. That guy has 10 million shares, so he makes $2.5 million in qualified dividends each quarter, totaling $10 million over the course of the year.
(He might also sell some of those shares, but since he’s owned them for years, any money he makes from that sale are also taxed at the same lower rate that applies to qualified dividends.)
So, what’s this person’s tax bill? Remember, this guy just made $10.5 million this year – a $500,000 salary and $10 million in dividends. That person is going to pay $2,151,026 in federal income taxes. That’s a 20.5% effective income tax rate.
Remember earlier, when we looked at the person earning $300,000 as a normal salary? That person is actually paying a 27% effective income tax rate.
This is almost exactly how Warren Buffett pays a lower tax rate than the people who work for him. The vast majority of his income comes from qualified dividends and long term capital gains, both of which are taxed at that lower rate.
How Can Ordinary People Take Advantage of This?
So, how can an ordinary person take advantage of this knowledge and use it to trim their tax bill a little bit? Here are some strategies that can work.
Live lean. Try as hard as you can to spend as little as possible. Trim your household expenses. Get involved with low-cost hobbies, especially ones that might earn you a little money. Move to a lower-cost area. There are lots of ways to do this, but it’s hard to ever put yourself in a better financial place if you’re spending all of your income.
Get rid of debts. Debts devour your monthly cash flow. You need monthly cash flow to invest consistently. The interest on your debts is gobbling up your post-tax income, which is really painful. Get rid of your debts as quickly as you can. If you’re living lean, channel that money toward debt freedom.
Invest for the long term. You can’t take advantage of the things described here – qualified dividends, long term capital gains – if you don’t hold onto your investments for a while. So, when you start investing, invest in things that you’re happy to sit on for a while. I especially like index funds for this as they’re diversified and many of them pay dividends. Once you own them for a while, the income generated from those investments are going to be taxed at that lower rate.
Use tax-advantaged accounts. Investing in a 401(k) and/or a Roth IRA and/or a college 529 account is a great way to reduce your tax rates over the long haul. Each of these accounts provides tax advantages in various ways. The 401(k) delays your tax payments until you’re retired, which means you’re earning less and paying a lower tax rate, while a Roth IRA eliminates taxes on the money you earn (as does a 529 if the money is used for educational expenses).
Ask for (some) compensation in the form of stocks. If you work for a company, see whether or not you can receive some of your compensation in the form of stocks. This not only gets you on board for earning qualified dividends and (eventually) long term capital gains from selling them, it also indicates that you’re professionally interested in the long term health of the company. This can be risky – if you can, you should balance this by investing in other things so that you don’t have all of your eggs in one basket.
All of these strategies will either reduce your tax rates over the long term or set you up for using those strategies.
Like it or not, tax laws in the United States are designed to benefit investors. Most wealthy people are investors. Thus, the tax laws benefit wealthy people.
Having said that, the only thing that’s keeping you from being an investor is your own financial choices. If you’re spending everything you earn, you’re choosing to not invest. You’re choosing to accept the higher tax rates.
It is a hard choice to make. It requires financial discipline to get there. But once the ball starts rolling, it’s amazing.