Tricks millionaires use to pay less tax

The U.S. tax code is designed to collect higher taxes from households with higher incomes. With tax brackets ranging from 10% on the lower-income side to 37% for the wealthiest, “higher-income Americans tend to face higher marginal tax rates and pay more in federal income taxes,” the nonprofit Tax Foundation says.

So, why do we hear about the wealthy paying less tax?

To understand how millionaires often reduce their taxes, it’s helpful to look at the strategies and advice they receive. Here are some of the tax tricks millionaires use to lower their tax burden.

Read more: How billionaires get away with paying less income tax

Knowledgeable investors know about asset allocation: managing risk by utilizing an assortment of investments that balance a portfolio for volatility and long-term returns.

Brian Schultz with Plante Moran Wealth Management says millionaires take asset allocation to another level: tax efficiency.

One strategy: Assets generating higher cash flow are parked in tax-deferred retirement accounts, such as IRAs and 401(k)s.

“They’re not taxed currently on the income, and then if they leave those to charity, they never get taxed on it,” Schultz told Yahoo Finance. He also notes that lower balances in tax-deferred accounts can reduce required minimum distributions at age 73, which trigger income taxes.

Meanwhile, high-growth investments are held in taxable accounts.

“If I’ve got a portfolio of stocks or stock mutual funds in my taxable accounts, and sell those to provide assets for my living expenses, I’m getting capital gains rates on the growth. If I don’t spend the money and I don’t sell, I get a step-up in basis [at death], so the growth is never taxed,” he added.

Attorney and financial advisor, Sharon Winsmith of Winverse online financial education, agrees.

“Do everything possible to avoid accumulating large balances inside 401(k) plans or traditional IRAs,” Winsmith said. “If you do have large balances, I would suggest looking to do backdoor Roth-IRA conversions to get as much money out of traditional 401(k) and IRA plans as possible.”

For millionaires with large unrealized profits on taxable investments, avoiding taxes takes additional effort.

“Even though the capital gains tax rates are lower than ordinary income tax, you’re still paying taxes,” said Schultz. “One option available is a client could borrow against their assets to fund their lifestyle.”

For example, an investor with a $20 million stock portfolio who wants to spend $200,000 a year in retirement could use the assets as collateral for a loan. The investor borrows $200,000 at 7% interest. She might pay $14,000 in interest that year — but zero taxes.

“At the end of the year, I’ve still got all my assets growing, but I now have a $200,000 line of credit against my investments. I had no income taxes because I didn’t have to sell anything — so I had no gains to recognize. And I had no taxable IRA distributions,” Schultz said.

The strategy is called Buy, Borrow, Die.

“This strategy allows you to pass down assets to your heirs without ever paying capital gains taxes on the appreciation in those assets. The strategy also forces you to be a disciplined investor by encouraging you to only buy assets you are willing to own long-term, helping you avoid making short-term, emotionally driven investment decisions,” Winsmith added.

Read more: How are dividends taxed?

Wealthy investors also use trusts to lessen taxes. Some trusts may hold highly appreciated stock — with no step-up in cost basis for heirs. That could leave the heirs with a huge capital gains tax bill.

Schultz said that in a grantor trust, the strategy known as substitution power can allow a transfer of assets of equal value. By swapping in cash, bonds, or other assets that are not highly appreciated, the heirs can avoid a tax shock.

“So yes, my heirs will not get a step up in basis for that $5 million of assets, but there’s very little unrealized gain anyway,” Schultz said. “But I pulled that $5 million of stock that had grown over time back into my estate. Now my heirs will get a full step up in basis … and help minimize the tax my family or my heirs will pay.”

One tax trick the wealthy are extremely adept at: reducing — or moving — personal income to a less-taxed category.

“Under current tax laws, I recommend seeking every opportunity possible to convert earned income into either self-employment income or business income,” Winsmith said. “W-2 salary income is taxed at the highest rates and is the least efficient way you can make money.”

She noted that many smaller to mid-sized companies are willing to structure compensation so that you are treated as an independent contractor.

“This allows you to take advantage of tax deductions otherwise unavailable to full-time employees, such as deductions for expenses, the Qualified Business Income (QBI) deduction, and the home office deduction,” she added.

With federal estate tax exemptions now $15 million ($30 million for married couples), if a wealthy person has two children and wants to leave each of them $5 million, anything beyond that $10 million that is donated to charity is untaxed.

“That’s an efficient estate plan, it’s tax efficient,” Schultz noted.

However, he says it’s actually more tax-efficient to make charitable donations during your lifetime.

“If they were willing to make some donations to charity while they were still alive, now you get those assets out of your estate, plus you also get an income tax deduction for making the charitable donation,” he added. “Honestly, a lot of times it’s sort of a mindset shift for clients when they’re thinking about that for the first time. They get to see some of their money go to work to help support those causes that they care about.”