Sunday, August 16, 2020

Published 9:08 PM by with 0 comment

Why Are Tax Rates So Low for Rich People?

This is an enormous topic, so I'll just focus on investments, cover some basics here, and provide simple examples. A major reason that the tax rates are so low for rich people is that investments are often taxed lower than normal income and rich people make a lot of money from their investments.

There are many classes of investments. There also many investment account types. To keep this simple, I will cover the basics of bank accounts, bonds, and stocks, and also cover how 401ks and IRAs work. 

Overly simplified, investments pay you in two ways:

  1. You get some yield from them (interest, dividends, etc.)
  2. They increase in value (capital gains)
You typically owe taxes on any of #1, and any of #2 that you sold. For #2, the taxes are typically on the amount you gained in the sale...that is, if you bought for $25 and sold for $35, you're taxed on the $10 gain.

Tax types

These are generally taxed in a few different ways. Considering only federal taxes here to keep it simple:
  1. 'Marginal rate' which means at your income rate; if you're in the 32% bracket, they're taxed at 32%
  2. 'Ordinary dividends'; same as 'Marginal rate'; these are typically dividends on stocks you've held for only a short time before the dividend was paid out
  3. 'Short-term capital gains'; same as 1 and 2; these are capital gains on things that you sold less than a year after purchasing
  4. 'Long-term capital gains'; less than or equal to marginal rate; vary from 0 - 20%; these are capital gains that aren't short-term
  5. 'Qualified dividends'; dividends that don't fit in #2; these are taxed like long-term capital gains
  6. 'Exempt-interest dividends'; dividends that are not subject to taxes...typically municipal bonds
Summarizing then, you basically have two tax rates: your normal income one that covers interest income, ordinary dividends, short-term capital gains, and a few others, and the investment rate that covers long-term capital gains and qualified dividends. Those last three are why you'll often hear about billionaires having low tax rates. Once you're wealthy enough that your income is mostly from investments, you primarily pay the (lower) investment tax rates.

Income example

How does this work with a real example?
  1. You had $10,000 in a savings account yielding 1% for 1 year.
  2. You had $10,000 in a municipal bond fund yielding 1% for 1 year.
  3. You had $10,000 in a treasury bond fund yielding 1% for 1 year.
  4. You had $10,000 in stocks that paid out a 1% (qualified) dividend for 1 year.
  5. You are in the 24% tax bracket.
What was the net gain on each of those after subtracting your taxes?
  1. You earned $100. You owe $24 in taxes on it. Net yield was 0.76%.
  2. You earned $100. You owe $0 in taxes on it. Net yield was 1%.
  3. You earned $100. You owe $24 in taxes on it. Net yield was 0.76%.
  4. You earned $100. You owe $15 in taxes on it (qualified dividends are 15% rate for 24% tax bracket). Net yield was 0.85%.
You can see that municipal bonds dominate here. For equivalent yields, they pay out 1/0.76 - 1, or 32% more than the savings account. In table form, for a base yield of 1% in the 24% tax bracket:

InvestmentReal Yield
Municipal Bond1%
Stock (Qualified Dividend)0.85%
Savings Account (Interest)0.76%
Treasury0.76%


We covered a lot so far. To recap highlights...
  • Municipal bond yields are often not subject to federal tax at all.
  • Most dividends are taxed at a much lower rate than ordinary income.

Capital gains example

Now let's try some capital gains examples:
  1. You buy $100 of a stock on 01-Jan-2019 and sell for $200 on 02-Jan-2019.
  2. You buy $100 of a stock on 01-Jan-2019 and sell for $200 on 02-Jan-2020.
  3. You buy $100 of a stock on 01-Jan-2019 and sell for $50 on 02-Jan-2019, then use that $50 to buy a different stock on 02-Feb-2019 and sell it for $200 on 02-Jan-2020.
What do you owe in each case?
  1. $24. You sold for a gain after holding for only 1 day...that's a short-term capital gain of $100, so you owe $24 (ordinary income rate).
  2. $15. You sold for a gain after holding for more than 1 year...that's a long-term capital gain of $100, so you owe $15 (long-term capital gains are 15% rate for 24% tax bracket).
  3. $10.5. You took a $50 loss in 2019, and a long-term capital gain of $150 in 2020. The $50 loss resulted in a capital loss of $12 (24%*$50), and the $150 gain results in a tax of $22.5, so you owe $22.5 in 2020 and had a net of $10.5 in taxes. 
Note that #3 is better than #2 even though both represent a $100 gain over the same time period. You can write off the loss in 2019 as ordinary income while the gain is the lower long-term capital gains rate. This is called 'tax loss harvesting'. Some brokers like Wealthfront do this automatically for you. In table form, if you're in the 24% tax bracket and make $100 total in capital gains, you owe the following tax depending on the sale details:

InvestmentEffective Tax Rate
Short-term gain24%
Long-term gain15%
Tax-loss harvested10.5%

Account types

You might have heard of 401ks, Roth IRAs, 529s, etc. What are these? The two most common (I think) are 401ks and Roth IRAs, so briefly:
  • a 401k lets you invest money without paying taxes on it; you pay taxes when you withdraw; this is very helpful if you make more money now than you will in retirement (assuming tax brackets don't change)
  • a Roth IRA lets you invest taxed money and then you pay no taxes on the gains (dividends, capital gains, etc.); i.e., every tax in the examples above would be 0 like the municipal bond one
Paying no taxes either on the invested income or on the gains can be hugely beneficial. It's generally ideal to max those two account types out each year if you can. For example, compare the 401k with a taxable account for $5,000 of income invested that doubles over 10 years and is cashed out then. Assume you were in the 24% bracket when you earned it and are in the 22% bracket when you withdraw it:
  • taxable account: $5,000 pre-tax = (1 - 0.24)*$5,000 = $3,800 invested; doubled means gain is $3,800; that's taxed at 15%, so you end up with $7,030
  • 401k: $5,000 pre-tax; 401k is invested pre-tax so all $5,000 goes in; doubled means gain is $5,000; that + original $5,000 are taxed at 22%, so you end up with $7,800
That is a significant difference. The gain on the 401k money is 56% while the gain on the taxable account money is 41%. 401ks have an additional advantage in that many employers match funds. Running the numbers assuming your emlpoyer matches half what you deposit:

401k with 50% employer match: $5,000 pre-tax; 401k is invested pre-tax so all $5,000 goes in; employer adds $2500; doubled means gain is $7,500; that + original $7,500 are taxed at 22%, so you end up with $11,700.

That's awesome...you effectively got a gain of 134%.

Similar example for Roth IRA:
  • taxable account: $5,000 pre-tax = (1 - 0.24)*$5,000 = $3,800 invested; doubled means gain is $3,800; that's taxed at 15%, so you end up with $7,030
  • Roth IRA: $5,000 pre-tax = (1 - 0.24)*$5,000 = $3,800 invested; doubled means gain is $3,800; that's untaxed, so you end up with $7,600
Not quite as significant in this case as the 401k in this case, but still great...Roth IRA gain was 52% while taxable account gain was 41%.

To summarize those in a table, if you're in the 24% tax bracket now and 22% tax bracket in retirement, an investment that doubles yields the following for the various account types:

InvestmentYield vs pretax investment
Taxable41%
Roth IRA52%
401k56%
401k (with 50% employer match)134%

Note...you might have a 401k plan through your employer that allows constant/in-plan conversion to a Roth IRA. This can be the best of both of the above. Basically, you:
  • max out your tax-free 401k contribution
  • add after-tax money to 401k (this lets you get above the ~$19k annual limit)
  • convert the after-tax portion to a Roth in-plan so that it then grows tax-free
This lets you get way more tax-free growth, but is limited to people who make enough to need more than $19k/year invested and have employer plans that allow this. This is often called a 'megabackdoor' in case you want to ask your company's plan manager about it.

Living off of investments

Imagine you're single and live off of capital gains. How much tax will you pay?

There is no exact answer because it depends on a lot, but you can get a surprisingly large amount of money tax-free with this setup. Imagine all of your money is in taxable accounts to make it hard. Imagine you invested $600,000 total, and it's now worth $2,000,000. Remember from above that you are only taxed on the gains on your investments when they're sold and not the total amount sold. Current tax brackets have 0% capital gains tax on your first $40,000 in income. If you need $60,000/year to get by, you could thus sell:
  • $40,000 of gains
  • $20,000 of initial investment
That will give you $60,000, tax-free, even though your account is taxable (assuming this is your only income). If you're married, this is doubled. If you have some money in a Roth IRA, you can get out even more since those gains aren't taxed. Making this even crazier, say you do this until you die and have $1,200,000 in gains left over to pass on in inheritance. Because of a (IMO) loophole called 'step up in basis', the cost basis is reset to current value, so no one ever pays taxes on those gains.

It's important to note that the above does not factor in tax-free income from municipal bonds or the standard deduction, so you can actually get even more income without paying any income taxes.

Not covered here

There are many tax advantages when it comes to real estate. There are some crazy complicated tax rules around stock as income from a company. There are also crazy complicated tax rules around income from things that you own (e.g., a business). Some people also just lie on their taxes, hide money, etc.

Summary

Using simple strategies, it is very easy to get taxes on investments well below 20%. None of the above are tax evasion or crazy loopholes or anything. Some will change over time (e.g., I personally hope the step up in basis is removed), but there are many completely legitimate ways to get investment taxes lower than ordinary income. You also don't need to be a billionaire to take advantage of them. Over half of all working Americans have 401ks for example. This also leads to a few simple bits of advice:
  • if you have access to a 401k through your employer and they match anything, take advantage of it if at all possible
  • max out a Roth IRA every year if at all possible
  • try to hold stocks for long enough to get the lowered tax rates
  • if you want a broad portfolio (e.g., mix of municipal bonds, treasuries, and stocks), put the worst tax-offenders (treasuries, then stocks) in the tax-shielded accounts
  • consider tax implications when selling investments (e.g., try to share older shares so you don't get hit with short-term capital gains taxes)

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