The Tax Distinction Between Wealth and Earnings
Recently, I participated in a routine year-end tax planning conference with a client who had a very good income year. In expressing her displeasure over her looming tax obligation, my client lamented, “I wish I knew all the tricks that rich people know to avoid paying tax!”
Setting aside the fact that 99% of Americans would consider her to be one of “those” people, her comment got me to thinking about the story a few years back about Warren Buffett paying tax at a lower rate than his secretary. How can that be? I am sure Mr. Buffett’s secretary is well paid, but how is it possible that she could pay tax at a higher rate than one of the wealthiest people on the planet? The answer lies in the distinction between wealth and earnings.
Wealth and Earnings are the same, right?
It is easy to conflate wealth and earnings, but they are really two different financial measures. Wealth is a measure of the assets you have amassed over your lifetime – bank accounts, investments, retirement savings, real estate, cars, businesses and personal effects – minus what you owe on those assets. Earnings are what you receive from your labor as an employee or business owner. Whereas wealth is generally inherited or amassed over time, earnings are a more immediate reflection of the financial value of your work.
So, is it possible to have wealth without earnings and earnings without wealth? Yes, and yes. While it is easier to amass wealth with higher earnings, you can build wealth at any nearly any earnings level by consistently living beneath your means. The Millionaire Next Door is a great read on how to build the financial habits necessary to make this happen.
By contrast, consistently living at or above your means will result in little to no wealth accumulated regardless of your earnings. This is especially true if you spend significantly on items that don’t build value over time – cars, travel, food, most fun things!
What does this have to do with taxes?
Our tax rules generally favor the wealthy over workers. I have not reviewed Mr. Buffett’s income tax return, but it has been widely reported that he takes a salary of $100,000 per year and that this salary has remained the same for 25 years. From a tax standpoint, this low salary saves Mr. Buffett a considerable amount of tax. How? Our tax system levies tax at rates from 10% to 37% on wage income. Additionally, wages are also tagged with Social Security tax (6.2% on wages up to $142,800) and Medicare tax (1.45% and up on an uncapped amount of wages). As you can see, wage earners at the highest level can easily surpass a combined tax rate of 40% on of those earnings.
Wealthy taxpayers with little or no wage income, on the other hand, are treated far better by the current tax rules. First, wealthy taxpayers have an ability to craft investment strategies to receive income in tax-advantaged ways. The federal tax rate on dividends and capital gains can go as low as 15% and is capped at 20%. Income from municipal bond investments is completely free of income taxes. And except for a Medicare tax of 3.8% on investment income over $250,000, Social Security and Medicare taxes do not come into play at all on investment income.
An additional strategy of the wealthy is to turn off the income spigot by borrowing against assets they already own. Money received in the form of a loan is tax-free to the recipient based on the principle that this money has to be repaid at some point. This repayment may happen when the underlying asset – a home, an investment portfolio, a life insurance policy – is eventually sold. That loan repayment may not happen until after the death of the taxpayer.
For those that earning a living by the sweat of their brow, there is no immediate tax relief. However, careful planning and saving can result in a good standard of living accompanied by a better tax situation. Then you can be the envied rich person with all the tax tricks!