It might surprise you to learn that the top 25 wealthiest people in America paid only $13.6 billion in federal income taxes between 2014 and 2018, despite their total income increasing by $401 billion during that period. This equates to a true tax rate of just 3.4%. Given that 2024 tax rates range from 10% to 37%, with higher rates applied to higher income levels, this discrepancy raises significant questions. According to estimates by the US Treasury, over $150 billion in taxes owed by the top 1% goes unpaid annually. How is this possible? The answer lies in the access the wealthy have to several sophisticated tax-saving strategies:
1. The Backdoor Roth IRA
One popular strategy among high-net-worth individuals (HNIs) is the backdoor Roth IRA. This allows them to bypass income and contribution limits while avoiding taxes on future withdrawals. Traditional IRAs compound pre-tax money over time, with gains taxed upon withdrawal. Contributions to these accounts are tax-deductible, and withdrawals are penalty-free after age 59½.
In contrast, Roth IRAs involve post-tax contributions, with future withdrawals being tax-free and no required minimum distributions. However, to open a Roth IRA, single filers' modified adjusted gross income (MAGI) must be below $153,000 in 2023 or $161,000 in 2024, and those filing jointly must have a MAGI below $228,000 for 2023 and $240,000 for 2024. These thresholds often prevent high-income individuals from contributing directly to Roth IRAs. As a workaround, millionaires create backdoor Roth IRAs by converting traditional IRAs to Roth IRAs, as there are no income limits for opening a traditional IRA or rules about who can convert them.
When converting a traditional IRA to a Roth IRA, the individual owes a one-time tax payment on the pre-tax contributions and capital gains up to the conversion day. After the conversion, no further taxes are owed on the Roth IRA.
2. Deferring Real Estate Taxes for Net-Worth Growth
HNIs frequently invest in tangible assets like real estate to hedge against inflation and protect their portfolios from recessions. If you sell a property within one year of purchasing it, taxes on short-term capital gains can reach 37%. However, long-term gains on properties held for over a year are taxed at up to 20%. To avoid these high tax rates, HNIs use a 1031 exchange, allowing them to defer taxes indefinitely by reinvesting the proceeds from one property sale into another.
Additionally, investing in Qualified Opportunity Zones (QOZs), which are economically distressed areas, offers tax incentives on capital gains. Properties held in QOZs for at least ten years may appreciate tax-free. Even a five-year investment in a QOZ property can result in a 10% capital gains tax exclusion.
3. Claiming Tax Deductions on Business Assets Depreciation
HNIs can also maximise their tax savings by claiming deductions on business assets. Securing Real Estate Professional Status (REPS) and combining it with a 1031 exchange unlocks significant tax benefits. REPS requires dedicating most personal service time to real estate activities, allowing individuals to deduct real estate losses against ordinary income.
The IRS lists several depreciable assets, including equipment, vehicles, copyrights, furniture, and patents used for business purposes. For 2024, the maximum allowable asset depreciation deduction is $1.2 million, up from $1.16 million in 2023.
4. Passing on Generational Wealth by Hiring Family
Transferring wealth to children early can significantly reduce tax liabilities. If done correctly, hiring children to work for a family business and paying them salaries can be deducted as business expenses, lowering overall business income.
The IRS stipulates that payments for services provided by children under 18 to a partnership or sole proprietorship are not subject to Social Security and Medicare taxes. Additionally, children's annual salaries up to $14,600 are not taxable in 2024, with a standard deduction of $13,850 for 2023.
5. Tax-Deductible Charitable Donations
HNIs often utilise charitable donations to reduce taxable income. The IRS permits itemised deductions for cash donations to trusts and charities up to 60% of adjusted gross income (AGI). Donations to qualified institutions can result in deductions up to 100% of AGI for higher tax breaks.
Many wealthy individuals establish private foundations or trusts to support charitable causes while reducing tax liabilities. Charitable Remainder Unit Trusts (CRUTs) provide a passive income stream during the donor's lifetime, with the foundation's assets going to charity thereafter. This strategy supports philanthropic goals and offers tax benefits, such as deferring capital gains tax on appreciated assets contributed to the trust. The Tax Cuts and Jobs Act increased the standard deduction to $12,000 for individuals and $24,000 for married couples, requiring taxpayers to exceed these amounts for itemised deductions.
