Why the wealthy are so low cost – Press Enterprise

A favorite binge-watching television series on several streaming services, “Trust” is a fictional drama about how J. Paul Getty, once the richest man in the world, and his family reacted when his grandson was kidnapped.

Before the kidnapping, the Getty character responds to his teenage grandson’s request for money, and they discuss why he cannot give him any even though they are worth billions.

Getty explains, “It’s a self-sustaining system that never pays a cent in tax because it never goes a cent into profit. For the purposes of accounting, Getty Oil runs at a loss, my boy. At a loss. We’re so poor, we could get milk tokens from the (expletive) British government.”

With the top marginal federal individual tax rate of 37% (not including additional Medicare taxes) and California’s top tax rate of 12.3%, it makes sense that any wealthy family would want to do whatever they legally could to not lose half of their income every year in taxes.

How billionaires do it

Billionaires paid only 23% federal, state and local taxes in 2018. Contrast this to 1950-1980, when billionaires (and millionaires) paid more than 50% in federal taxes.

It was also just reported last week that, with the move of Elon Musk from California to Texas, the three richest men in the country (Bill Gates and Jeff Bezos, both Washington state residents) likely will pay no state income taxes.

The wealthy who engage in sophisticated tax planning understand that individual income taxes are primarily a tax on consumption and that taxes are only paid on “take-home income.” Very little of their income is from wages, and they personally own almost nothing.

Much of the frugal behavior that seems odd in the rich is often actually tax-related. Getty did much of his own laundry and was known to charge guests for beverages and phone calls. Steve Jobs was known for wearing simple black turtlenecks. Laundry, clothing, and personal household expenses are not deductible. Mark Zuckerberg drives old cars that are valued at or less the depreciation limit. Even the amount of ransom Getty agreed to pay for his grandson personally was the legally deductible amount.

Warren Buffet, who is worth roughly $85 billion, claimed he paid only17.4% in income and payroll taxes last year while the 20 people in his office paid more than twice that. Yet. Buffet lives in the same home he bought in 1958 and eats breakfast at McDonald’s. His home and inexpensive breakfast will not cost much in after-tax dollars.

How much do most people pay?

If we “regular” folks were also able to pay nothing in income taxes, what impact would that have on our wealth? For example, a two-income household earning $100,000 would have paid $8,600 (rounded) federal and $2,800 (rounded) state tax utilizing a standard deduction with no kids in 2020. If they could save that $11,400 every year and invest it earning 6% annually, they would have accumulated over $900k in additional savings (due to compound interest) in 30 years. It is not a billion, but it still is significant.

But wait. Note that the effective combined federal and state tax rates on our example couple are 11.4% ($11,400 tax/$100k income), and like the billionaires, they paid far less than the top marginal rate of 49.3%. This is because the couple did not make enough to pay the maximum marginal rate. They would only pay the top marginal rate of 37% if their taxable income was over $622K.

A taxpayer’s effective tax rate (or average tax rate) is the percentage of income they pay in taxes, like the 11.4% example above. By contrast, a taxpayer’s marginal tax rate is the tax rate imposed on their last dollar of income. Taxpayers’ effective tax rates are lower — usually much lower — than their marginal rates.

So, when you hear on the news that the top marginal income tax rates went up or down, understand that those rates are for the highest income earners and generally do not apply to most of us.

How much do I pay?

To find out what effective and marginal tax rates you are currently paying, print a five-year summary report from your tax program or ask your tax professional to print one for you. The report will show a summary of your income, deductions and taxes paid over the past five years and will also show the effect that the 2017 Tax Cuts and Jobs Act (TCJA) had on your taxes in 2018.

Can regular people plan?

Back to our example, is there anything our couple could do to reduce their taxes, and at 11.4% total state and federal tax, is it even worth it for them to do tax planning?

First, what if they bought a home? If we base the home’s purchase amount on their taxable income, a home purchase will probably not decrease their taxes. With the tax law change in 2017, the standard deduction was increased to $24,000, and this eliminated the ability to itemize for 90% of Americans.

What if they had a couple of kids? They would save $1,000 in tax in the form of a credit for each child. Would contributing to their 401(k) be worth it? At their tax rates, each dollar contributed to their 401(k)s would result in a tax savings of 11.4 cents or less.

In light of this, would I advise them not to buy a home or contribute to their 401K? They should still consider those strategies but primarily for the other financial benefits like building equity and saving for retirement.

Upper-middle tax planning

The traditional tax planning benefits of reducing your income through tax-advantaged or small business investments or increasing your deductions by owning a home or giving to charity are increased the higher your marginal rate is. So, tax planning is still essential for those of you who earn more than the median amount.

For higher-income clients, I recommend discussing with a financial adviser budgeting techniques and expense tracking to limit personal spending. At a minimum, your adviser or CPA should be able to review with you your personal financial statements and a budget. Learn what is tax-deductible and what is not and plan accordingly.

Don’t worry too much about tax changes

When I hear my clients or friends on social media worry that their taxes are going to go up with a change in administration or party in power, I usually want to give them a socially distanced hug and tell them that, no, the people in charge are not that concerned about collecting more from us.

The new administration has several issues on its agenda that are more important than repealing the TCJA of 2017 or making sweeping changes to the tax code.

The reality is there have only been two major tax acts passed over the past 40 years. The Biden tax proposal claims it would only increase the tax on those earning over $400,000, and most of the proposals probably will not go through. It is more likely that Congress, this administration, and the next administration will just let most of the existing rules and rates expire in 2025. Consider this one less issue not to have to worry about as 2020 finally comes to a close.

Michelle C. Herting, CPA, ABV, AEP, specializes in estate, trust and gift taxes, and business valuations. She has three offices in Southern California and is president of the Charitable Gift Planners of Inland Southern California.

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