Have you ever heard that multi-billionaire Warren Buffett pays a lower federal income tax rate than his secretary? It's true. And he isn't alone. Many ultra-wealthy American households pay surprisingly low effective federal income tax rates, and in some cases, no taxes at all. They accomplish this (legally) by using some of the most effective tax breaks available in the U.S. tax code.
The best part is that you can learn from many of these and apply them to your own life. No tax breaks are designed to only benefit billionaires.
Eight ways the rich avoid taxes
I won't keep you in suspense. Here are eight ways the wealthiest Americans reduce their tax liability -- or even avoid paying taxes altogether.
Read more: we researched free tax software and put together a list of the best options here
But here's a key concept to keep in mind. These strategies and tax breaks aren't exclusively available to the ultra-wealthy. Everyday Americans can (and do) benefit from these as well.
1. No taxes on unrealized capital gains
The No. 1 reason most billionaires pay a surprisingly low amount of taxes is because many don't have much income at all. Instead, their wealth is tied up in stock and other assets. Under U.S. tax law, you don't pay any tax on investment gains until you sell, no matter how much they've gone up. This is known as unrealized capital gains and can be a great tool to defer taxes on winning investments in your brokerage account.
2. Charitable deductions
How does Buffett pay a lower tax rate than his secretary? The answer is he donates billions of dollars' worth of Berkshire Hathaway stock to charity every year, and as he's entitled to do, claims some of these donations on his taxes. This effectively cuts his taxable income in half. While you and I are unlikely to have a charitable deduction equal to half of our income in any given year, taxpayers who itemize can certainly get a nice break for their generosity.
3. Long-term capital gains rates
Billionaires generate a disproportionate amount of their income from investment income -- both in the form of capital gains from investments they sell and dividend income they receive from their stocks. Profits from investments held for more than a year, as well as most dividend income, gets taxed at significantly lower rates than ordinary income.
4. IRAs
There's one particularly notable story of billionaire Peter Thiel who opened a Roth IRA and put shares of the company that would eventually become PayPal in the account. The account ended up being worth $5 billion and because of the tax-free nature of Roth IRA withdrawals, Thiel won't have to pay a dime in taxes on anything he withdraws from that account.
5. Pass-through income
As part of the Tax Cuts and Jobs Act, which went into effect in 2018, pass-through income (such as from an LLC or partnership) gets a 20% tax deduction. Many wealthy individuals are business owners, so they benefit from this, but it also applies to pass-through income from small businesses and self-employment income as well.
6. Tax breaks for homeownership
Homeowners get some extra tax breaks, specifically the ability to deduct mortgage interest and property taxes if they itemize. Now, there are certain instances of wealthy people stretching this a bit, such as deducting the interest on a yacht loan because it technically meets the definition of a second home. But the mortgage interest tax break saves millions of everyday Americans money every year.
7. Medical expense deductions
Taxpayers who itemize can deduct medical expenses that exceed 7.5% of their adjusted gross income (AGI). There are confirmed reports of people successfully using this to deduct expensive swimming pools as a "therapeutic" device, but the deduction can be used by anyone who has high medical costs.
8. Real estate investing tax breaks
Real estate investments benefit from a ton of tax breaks, including a big one called depreciation. In a nutshell, if you buy a rental property, you can deduct a portion of the price you paid for the property every year on your taxes. In many cases, this makes profitable rental properties show a loss for tax purposes.
When in doubt, ask for help
As a final thought, it's very important to mention that there's quite a bit of gray area in these (and many other) tax strategies. So, if you aren't sure whether a certain deduction or credit applies to you, it's a smart idea to seek help from an experienced tax professional who can evaluate your unique situation.
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FAQs
Billionaires (usually) don't sell valuable stock. So how do they afford the daily expenses of life, whether it's a new pleasure boat or a social media company? They borrow against their stock. This revolving door of credit allows them to buy what they want without incurring a capital gains tax.
Where do wealthy take their money to avoid taxes? ›
Outside of work, they have more investments that might generate interest, dividends, capital gains or, if they own real estate, rent. Real estate investments, as seen above under property, offer another benefit because they can be depreciated and deducted from federal income tax – another tactic used by wealthy people.
How do billionaires avoid estate taxes? ›
Make Charitable Donations
There are two types of charitable trusts: charitable lead trusts (CLTs) and charitable remainder trusts (CRTs). If you have a CLT, some of the assets in your trust will go to a tax-exempt charity. By donating to charity, you'll lower the value of your estate and end up with an extra tax break.
How do the rich use debt to avoid taxes? ›
Buy, Borrow, Die Strategy: This strategy involves buying appreciating assets, borrowing against them, and letting heirs inherit the assets to avoid capital gains tax. Managing Leverage Risks: Leveraging debt can increase wealth, but it also magnifies risk, liquidity issues, and costs, hence needs careful management.
What are some tax loopholes? ›
Examples of common tax loopholes
- Backdoor Roth IRAs. Backdoor Roth IRA is a term used to describe how high earners get around Roth IRA (Individual Retirement Account) income limits. ...
- Carried interest. ...
- Life insurance.
Increased taxes on the wealthiest individuals could lift people out of poverty, address the climate crisis, fund childcare, and create well-paying jobs.
Do rich people get social security? ›
The amount a person receives in Social Security benefits is not directly affected by their current income or wealth. Therefore, even if someone is a millionaire or billionaire, they can still receive Social Security benefits if they have a qualifying work history.
Who has paid the most taxes ever? ›
CNBC's Robert Frank reports on Elon Musk's tax bill which is the largest in history. Musk will pay a total of $12 billion for 2021.
Why does Tesla not pay taxes? ›
Despite this, the company's total federal income tax over that period was less than zero—it received a $1 million refund. That's because Tesla has benefited from generous government subsidies in the form of grants and tax credits for clean-energy projects, whose value has been calculated between $3 and $5 billion.
At what net worth does a trust make sense? ›
Many advisors and attorneys recommend a $100K minimum net worth for a living trust. However, there are other factors to consider depending on your personal situation. What is your age, marital status, and earning potential? At what point in time will your focus shift from wealth creation to wealth preservation?
The wealthy often use trusts to safeguard their money and minimize their tax burden. While trusts can be created by anyone, many people in the middle class are unaware of the advantages they offer. As a result, they miss out on financial benefits and asset protection.
How to grow your wealth tax free? ›
Maximize tax-advantaged retirement accounts like 401(k)s, IRAs, and HSAs. Contribute as much as you can afford. Invest in tax-advantaged assets like municipal bonds, REITs, growth stocks and tax-exempt assets. Consider strategies like tax-loss harvesting and tax-gain deferral to minimize taxes on investment returns.
What are the biggest tax loopholes for the rich? ›
12 Tax Breaks That Allow The Rich To Avoid Paying Taxes
- Claim Depreciation. Depreciation is one way the wealthy save on taxes. ...
- Deduct Business Expenses. ...
- Hire Your Kids. ...
- Roll Forward Business Losses. ...
- Earn Income From Investments, Not Your Job. ...
- Sell Real Estate You Inherit. ...
- Buy Whole Life Insurance. ...
- Buy a Yacht or Second Home.
Wealthy people aren't afraid of borrowing. But they typically don't borrow money to live beyond their means or because they failed to save for emergencies or make a plan to cover expenses. Instead, rich people tend to use debt as a tool to help them build more wealth.
Where do the wealthy take their money? ›
Wealthy individuals put about 15% of their assets into fixed-income investments. These are stable investments, like bonds, that earn income over a set period of time. For example, some bonds, like Series I Savings Bonds, pay 4.3% right now and pay out the interest every six months.
Are rich people avoiding taxes? ›
The nation's millionaires and billionaires are evading more than $150 billion a year in taxes, adding to growing government deficits and creating a “lack of fairness” in the tax system, according to the head of the Internal Revenue Service.
What is the wealthy crackdown for the IRS? ›
Major new initiatives in recent months have included an aggressive pursuit of high-wealth earners who don't pay their full tax obligations, such as people who improperly deduct personal flights on corporate jets and those who just don't file at all.
How much does the top 1% pay in taxes? ›
High-Income Taxpayers Paid the Majority of Federal Income Taxes. In 2021, the bottom half of taxpayers earned 10.4 percent of total AGI and paid 2.3 percent of all federal individual income taxes. The top 1 percent earned 26.3 percent of total AGI and paid 45.8 percent of all federal income taxes.
