Smart Tax Planning

Here are 5 ways the super-rich manage to pay lower taxes

Key Points
  • The super-rich are always looking for ways to decrease the amount of taxes they have to pay. 
  • But what are the things they do to ease their burden? 
  • Experts break down 5 common strategies that help save their clients money. 

The more money you make, the more taxes you pay — right?

Not necessarily.

While the U.S. tax code is structured so that high earners pay a higher tax rate, the ultra-wealthy often take advantage of laws that enable them to lower their effective tax rate.

"In general, America's wealthy are different when it comes to tax planning because of the options they may have with categorizing the assets they hold," said Ron Carson, founder and CEO of Carson Group and co-author of "Avalanche: The 9 Principles for Uncovering True Wealth."

"Their net worth often presents opportunities when tax planning to help protect their assets," he added.

Warren Buffett speaks to CNBC's Andrew Ross Sorkin

Billionaire Warren Buffett, CEO of Berkshire Hathaway, has repeatedly pointed out the disparity, advocating that rich Americans pay higher taxes. To make that argument, he famously noted that he pays fewer taxes, on a percentage basis, than his secretary and other employees, since a bulk of his wealth is in stock rather than wage income.

The ability of the wealthy to bring down their taxes is nothing new, but there has been a recent rallying cry to make the rich pay more. Sen. Elizabeth Warren, who represents Massachusetts and launched her campaign for the 2020 Democratic presidential nomination earlier this month, has proposed a 2 percent tax every year on households with assets over $50 million and 3 percent on households with assets over $1 billion. Rep. Alexandria Ocasio-Cortez, D-New York, wants to slap a 70 percent marginal tax rate on income above $10 million. And independent Sen. Bernie Sanders, from Vermont, is looking at an estate tax hike.

Explore the possibilities of categorizing your assets into three tax locations — taxable, tax-deferred, and tax-free — to best protect what you've built.
Ron Carson
Carson Group CEO

The current tax code, overhauled when the Tax Cuts and Jobs Act was signed into law in late 2017, brought down the tax bracket on the highest earners. The wealthiest now pay a top rate 37 percent on their taxable income, down from 39.6 percent. Still, it could take a big bite out of a billionaire's wallet — so that means thinking ahead on how to save.

"For wealthy people, tax planning is not something done at the end of the year," said CPA Lisa Featherngill, a member of the American Institute of CPAs' Personal Financial Planning Executive Committee. "It's top of mind throughout the year."

So if you want to find a way to lower your taxes like the rich do, it could be a good idea to meet with a financial advisor or CPA.

"Explore the possibilities of categorizing your assets into three tax locations — taxable, tax-deferred, and tax-free — to best protect what you've built," said Carson, a member of the CNBC Advisor Council.

While there are different, creative ways the rich try to bring down their taxes, here are five of the most common strategies on their radar.

Charitable donations

Giving money to non-profit organizations has long been a way for the wealthy to get a deduction on their taxes. And under the new tax law, the amount you can deduct has increased — to 60 percent of your adjusted gross income, up from 50 percent.

One way the rich have been taking advantage of the deduction is creating conservation easements, said Featherngill, who is also the national head of legacy and wealth planning at Abbot Downing in Winston-Salem, North Carolina.

Getting the most out of your charitable donations
Getting the most out of your charitable donations

A big plot of land may have some intrinsic value. "Maybe it is on a migration field for birds, maybe it abuts a river or maybe it is some green space in an area getting overly developed," she explained. "Often times you can work with land conservation trusts and you can take a charitable deduction for the value of the conservation easement that you put on the property."

The average filer can, of course, also take a deduction for charitable contributions — but they have a higher hurdle to overcome. In order to do so, they have to itemize their taxes. The Tax Cuts and Jobs Act nearly doubled the standard deduction to $12,000 for individuals and $24,000 for married couples filing in 2018, so the itemized deductions would have to exceed those amounts.

Increasing equity exposure, managing gains

The wealthy like to invest in stocks because when it comes time to sell, the taxes are typically lower than the rates on wage income — if, that is, the equity was held for more than a year. They can also afford to take bigger risks.

"Many who have higher net worth also have higher risk tolerance preferences and risk capacity, so target date and low risk funds don't always make sense," Carson said.

Long-term capital gains tax rates are zero, 15 percent and 20 percent for 2018, depending on your income. Federal tax brackets on wages go from 10 percent for the lowest earner to 37 percent for the highest. Short-term capital gains taxes on stocks held for less than a year are tied to your federal tax bracket.

The wealthy also look to manage those capital gains and losses to their tax advantage, Featherngill pointed out.

For example, there tends to be a "flurry of activity" at the end the year, with people trying to take losses to offset some of the gains they reaped earlier in the year. She's also seeing people investing in opportunity zone programs, which invest in low-income communities, as a way to defer capital gains.

It's something that can be done by anyone, not just the rich. "If the gain is sizeable enough, in terms of material enough for them, they can look at ways of deferring tax on the gains," she said.

Managing assets like a business

One way to save on taxes is creating a structure — such as a limited liability company, or LLC — to manage multiple investments, said Featherngill. It could include portfolio assets, real estate or a business.

While it could get complex, there may be opportunities to save money while at the same time creating a governance structure for your assets, she explained. "If the LLC is a management company that provides oversight and advice to owners of the assets, under certain circumstances the expenses incurred by the LLC will be deductible as business expenses."

Moodboard | Getty Images

Estate and gift exemptions

Gift and estate deductions help bring down taxable income, but there is even more reason to take advantage of them now.

Thanks to the new tax law, the deductions have been temporarily doubled. Individuals can now claim up to $11.18 million, compared to the $5.29 million limit per person in 2017. The exemption expires after the end of 2025, so the wealthy are taking advantage, said Featherngill.

Many of them are setting up long-term trusts, such as a Delaware Dynasty Trust, which allows wealth to be passed down from generation to generation, she said. While it is subject to income taxes along the way, it will not be taxed as a gift if it meets the limit and will not be subject to estate tax when money comes out.

However, given the costs involved in setting up and running a multi-generation trust, it only makes sense when you have $5 million or more to commit, said Featherngill.

Defined-benefit plan

A defined-benefit plan, similar to an old-fashioned pension, allows business owners to contribute a substantial amount of money towards retirement.

In the right situation that can mean "well over $200,000 a year" for an individual owner, Carson said. "This can be a great way for a high net-worth individual running a successful business to set aside tax-deferred money above and beyond what they can put aside in a 401(k)."

Here are your income tax changes for 2019
Here are your income tax changes for 2019

It is particularly appealing to the rich because of the limitations on the 20 percent qualified business income deduction that is a part of the new tax law. The cap on the QBI is $157,500 in adjusted income for single filers and $315,000 for married couples filing jointly.

The contribution to a defined benefit plan "will help bring down the individual's taxable income, reducing their taxes for the current year," Carson noted. It can also bring them down below the thresholds "in order to qualify for the 20 percent deduction."

However, defined benefit plans won't work for every high-income business owner. You need to figure out if it fits your retirement savings and business operational needs, Carson said.

"You need to make sure it fits your retirement savings and business operational needs," he said. "For others, a SEP IRA, SIMPLE IRA, or 401(k) could be a cheaper and more effective way to save and reduce your tax bill."