There is a general misconception that high net worth individuals do not pay as much in taxes as those who fall under lower tax brackets. The reality is that wealthy individuals can pay a modest fortune in taxes each year. In fact, they may be subject to a higher income tax bracket and many other taxes that may not apply to those with a lower net worth.
Without the right tax planning strategy, high net worth individuals could see a substantial portion of their wealth eroded by taxes. As a wealthy individual, it is important that you understand the many types of taxation that affect you both while you are alive and after you pass away. This is the first step toward developing an effective tax reduction strategy.
Common Taxes Paid by High Net Worth Individuals
The vast majority of Americans earn a regular income from a salary, hourly wages or profits from a small business that they have started. The median income for a U.S. household in 2018 was just higher than $63,000. For the majority of Americans, regular income is applied to making ends meet and maintaining a comfortable lifestyle. Through a conservative lifestyle, some of the household’s money may be left over for savings, modest investments and extra items. Because of their common financial situation, these Americans pay the majority of their taxes in the form of income taxes. They may have common deductions, such as those related to business expenses, mileage, mortgage interest and property taxes. Many of the other types of taxes and types of tax deductions available simply will not apply to them. As a result, high net worth individuals are subject to a higher income tax rate and additional types of taxes.
What are the more common types of taxes that wealthier individuals are responsible for?
Do you earn income from a salary, commissions, royalties and other similar sources? For families who sit comfortably around the nation’s average household income of $63,000, the tax liability would be 22 percent. While this is a healthy sum of money, it pales in comparison to the tax rate that wealthy individuals pay. Wealthy individuals who are in the highest tax bracket are required to pay 37 percent of their annual income to the IRS.
This means that if an individual with $1 million in income did not take full advantage of tax deductions, the taxpayer would pay $370,000 to the IRS for that single year. The high net worth individual’s tax liability would be more than the total income that the average American earns in 5.5 years.
Capital Gains Tax
Wealth building becomes more challenging when you look at how you are taxed on the sale of assets. Whether you sell stocks, investment properties or other assets for a profit, that profit will be taxed separately from your income tax. The long-term capital gains tax may be as high as 20 percent.
Keep in mind that the capital gains tax does not have a flat tax rate. For households earning less than $40,000, no capital gains taxes are owed. If you are married filing jointly, the capital gains tax does not apply unless the family’s taxable income is more than $80,000. This means that the average household is not affected by capital gains tax. For high net worth individuals like you, however, this tax could significantly contribute to the erosion of the wealth that you have spent years building.
Estate and Gift Tax
Taxation even impacts generational wealth and your ability to pass your assets in full to your heirs. After you pass away, your heirs will be assessed a 40 percent tax on your taxable estate. Your taxable estate is offset by several deductions and a sizable exemption. The exemption is reduced by taxable gifts made throughout your lifetime. Even with the deductions and exemptions, very wealthy individuals with a high net worth must have an exceptional strategy to avoid losing a large chunk of their estate when they pass it on to their heirs.
The net investment income tax is an additional tax on investment income that exceeds a defined amount. Investment income is specifically from dividends, capital gains, royalties, interest and a few other types of investments. If you file as married filing jointly, any investment income over $250,000 will be charged a 3.8 percent tax. Keep in mind that this tax is in addition to the regular income tax that applies to the full amount of investment income.
Business Income Tax
Many high net worth individuals are self-employed or own their businesses. If you are self-employed, you are required to pay a separate self-employment tax on top of your regular income tax. As a self-employed individual, your net income from your work activities is taxable.
If you are a business owner, you must pay taxes on the business’s net income. The specific taxation rules vary based on the business entity type. In addition to paying a tax on the business’s net income, your business may be responsible for excise tax and for various types of employment taxes. These include the federal unemployment tax, the federal income tax withholding and Social Security and Medicare taxes.
Asset Protection Strategies for Wealth Building
You have worked hard throughout your life to build a healthy stream of income and valuable assets. To maximize the benefits of your hard work, you must develop an excellent taxation strategy. This should take into account ways to reduce your tax liability on an annual basis. It also should plan ahead to protect generational wealth after your passing.
Whether you need to reduce your personal or business tax liability, making charitable donations could be a smart solution. Individuals may deduct cash donations up to 60 percent of their adjusted gross income each year. The specific limits and rules for charitable donation tax deductions for businesses vary by entity. Regardless of whether you make a charitable donation personally or through your business, the charity must be an approved, non-profit organization.
Pass-Through Entity Income
One of the newer deductions that may apply to some business owners is the pass-through entity income tax deduction. For select business entities, up to 20 percent of the business’s net income may pass through to you personally without being taxed. There are several limitations and restrictions that apply. Also, this deduction is not available for C-corporation entities. However, it does reduce the corporate tax rate to 21 percent.
Real Estate Investments
For many high net worth individuals, investing in rental properties is advantageous. This type of passive investing activity provides you with the ability to grow your nest egg. The full value of the property will appreciate even though you may leverage your purchase with a loan. At the same time, tenants pay gradually pay off your loan for you through monthly rent payments. The property is also appreciating throughout this period of time. However, all of the operational experiences, mortgage interest and depreciation are written off. Therefore, the taxable income on some of these properties may be negligible even though you are enjoying a solid stream of income.
Notably, this type of passive investing activity offers another tax benefit. Through a 1031 exchange, you can transfer your net profit from the sale of real estate or some other types of assets into another approved investment without paying taxes on the profit. There are rules associated with a 1031 exchange, such as the types of qualifying assets and the time frame.
There are numerous strategies that you can apply in your living years to protect generational wealth from burdensome taxation. For example, you may re-title some of your assets into the heir’s name before you pass away. You could also purchase life insurance. Life insurance proceeds are not taxable. Therefore, you can instruct your heir to pay all estate taxes with the life insurance proceeds.
There are also numerous entities that you can roll your assets into. These include limited liability companies, irrevocable trusts and asset protection trusts. If your ownership stake in a business will be passed on to an heir, creating a succession plan now is essential. Each of these strategies has unique benefits and consequences. Consulting with an experienced estate lawyer is essential.
The Importance of Strategic Tax Planning
Through your hard work and strategic investing activities across your lifetime, you have amassed considerable wealth. Protecting your assets from various types of taxation in your living years and beyond is essential. Through passive investing, the smart use of various types of entities and other efforts, you can manage taxation so that your income and the value of your assets are preserved as much as possible.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.