How to Avoid Taxes Like a Billionaire
In June, Pro Publica revealed that they had somehow obtained tax records for many of the richest people in the United States including Jeff Bezos, Elon Musk, and Warren Buffett. To a financial planner, learning the details of how the billionaires do this is pure catnip. Their findings seemed shocking -- these billionaires somehow managed to pay only 3.4% in taxes on their skyrocketing wealth. For example, from 2014-2018 Warren Buffett’s wealth grew by $24.3 billion, yet he only paid $23.7 Million in taxes. How could that be!?
Whether or not you think billionaires ought to pay more tax, we can all agree that the IRS tax code is a disaster. We are not going to pontificate on our opinions of the tax code, but help educate our clients so that you can understand and strategize.
As you'll see, the strategies employed by the wealthiest Americans are not illegal nor are they even complex. Mostly, the reason these billionaires pay so little in relative income tax is that our tax code heavily favors business ownership (stock) to incentivize capital investment.
Here are the strategies they are using and how you (yes even YOU) can replicate them!
Don’t Sell Assets With a Capital Gain
The way ProPublica defined the “true taxes” of 3.4% was by comparing an increase in net worth to taxes paid. However, the IRS does not count the increase of stock as taxable income until you sell it (this is reasonable since stocks really do go down sometimes). Jeff Bezos, Warren Buffett, and the like founded incredibly successful companies, and aren’t selling their shares, so no taxable income (although their net worth goes up a lot).
How you can do this
We minimize selling assets with gains in taxable accounts. Better yet, we diversify around your taxable account by using Asset Location in your IRA (or 401k) and Roth IRA.
Be an Owner, not a Worker
Steve Jobs, Mark Zuckerberg, and many others only took a salary of $1/year. Jeff Bezos had the grandiose salary of $80,000/year. They do this because earned income is taxed at a higher rate than capital gains. These billionaires figure their stock going up in value is compensation enough for them.
How you can do this
OK, this one is going to be pretty hard to execute for most of us while working (even someone like Lebron James earns most of his income via working). However, becoming an owner of companies (in addition to your salary) is achievable for all of us. So buy as much in stocks as you can, as quickly as you can! For most of us, when we retire we will be able to eliminate those earned income taxes. This isn’t a perfect system, but odds of this working are a lot higher than you successfully founding a multinational trillion-dollar corporation (but we're rooting for you!).
Give to Charity
As you will remember from above, Warren Buffett has had tremendously low taxes relative to his wealth. Apart from avoiding capital gains, he is donating 99.5% of his wealth to charity. Money given to charity is obviously a huge deduction for him.
How you can do this
Perhaps you don’t have the ability to give away 99.5% of your wealth and still live a comfortable lifestyle. But we all have the ability to give SOMETHING to charity. To make sure it is as tax efficient as possible, you can gift appreciated stock, and lump your charitable deductions into as few years as possible (perhaps using a donor-advised fund to facilitate).
Use Debt to Avoid Capital Gains Tax
If Jeff Bezos and Elon Musk aren’t selling shares and aren’t getting much of a salary, you may have wondered how on earth they are paying for their lifestyles. They are often using a strategy labeled “buy, borrow, die.” In this strategy, rather than Jeff selling his Amazon shares, he would take a loan against them (like you do with your house) to pay for his living expenses.
How you can do this
For most people, you can have a fixed-rate 30-year mortgage (rates have never been better). For those of you with a large taxable account, you can potentially get attractive rates on borrowing against this account rather than selling assets and incurring a capital gain. Most people would rather not take on debt, but smart debt strategies can be a great way to avoid taxes.
Maximize that Roth IRA
One of the most interesting disclosures was that investor Peter Thiel had amassed $5 billion in his Roth IRA. This is an impressive accomplishment given that he only had $2,000 in the account in 1999 and that one can only contribute a few thousand to their Roth IRA per year.
How you can do this
Of course, you could fund your Roth IRA to the maximum extent possible using the back door Roth IRA method if eligible (and mega-back door Roth IRA if possible). You can watch for years where your income is down and convert from a traditional IRA into a Roth IRA. Even better, you can pair this with a large charitable gift in the same year to put more into the Roth IRA. Additionally, can put the assets with the highest expected returns in your Roth IRA (compensating with safer assets in your traditional IRA).
It's the Tax Code's Fault
The gut reaction of many was to assume the strategies of billionaires would be complicated, obtuse, and legally shady. Instead, it turns out that often they are using the same strategies that we have been recommending to many of you. Avoid capital gains, minimize your income, defer taxes where possible, and give to charity.
None of these strategies are without a downside. Using debt can help increase your wealth or destroy it. Owning one stock can get you extremely rich if it is amazon.com or extremely poor if it is pets.com.
For Quarry Hill clients, we are already employing these strategies where it makes sense. The tax code is always changing, but you can rest assured that your team of advisors is up to date on the latest strategies.