In June 2021, Pro Publica published an eye-opening journalistic piece covering tax records of many of the richest people in the United States including Elon Musk, Jeff Bezos, & Warren Buffett.
To a financial advisor, the chance to peek in & learn some new techniques is promising. Elon Musk presents a key example: In 2018 Musk paid $0 in federal income taxes despite his wealth's immense growth, which made him the 2nd richest person on Earth!
Despite these statistics, what's perhaps more shocking is Musk didn't actually do anything new or complicated.
It's clear the IRS tax code is messy, but that's an issue for another day. We need to develop & implement the most practical strategies in the meantime.
Key Strategic Theme:
By and large, our tax code incentivizes investment in assets (think stocks or real estate) versus earned income.
Here's how you (everyone!) can replicate the strategies of of the 1%.
1. Be an Owner, not an Employee
It’s simple: Equity compensation is taxed more favorably than earned income.
With equity compensation, one has the advantage of owning the stock’s upside, often not getting taxed until the stock is sold!
How you can apply this principle
This principle is difficult to implement unless you’re closer to retirement – we all need some form of immediate earned income.
- It’s nonetheless crucial we leverage all forms of investment accounts at our disposal to participate in long-term market growth that would minimize our “true tax rate.”
2. Don’t Sell Assets With Capital Gains
Easier said than done right? The idea of cashing in our gains is appealing to all.
Time in the market is critical nonetheless.
ProPublica’s article defines Musk’s “true tax rate” as the proportion of taxes paid relative to net worth growth. In reality, the IRS doesn’t treat net worth growth from stock gains as “earned income.” Simply holding stocks & receiving gains won’t increase your tax bill unless you sell.
How you can apply this principle
- Don’t sell assets in taxable accounts.
- Use tax-advantaged accounts to actively minimize tax burden & enable more efficient portfolio growth (e.g., contribute the $6k annual maximum to your Traditional IRA to reduce taxable income before contributing to taxable brokerage accounts).
3. Leverage Debt to Avoid Capital Gains Taxes
If Mark Zuckerberg takes a $1 salary & Elon Musk is paid a $56K salary, it might be unclear how he funds his day to day – this is understandable.
Often times, CEOs like Musk take advantage of their stock portfolios & take out loans using their accounts as collateral.These loans don’t qualify as income & therefore aren’t taxed.
How you can apply this principle
Those with larger taxable brokerage accounts can leverage the accounts to get attractive loans for major purchases. This is powerful because you get (1) competitive interest rates/ expanded loan access, (2) don’t have to sell any investments & therefore continue to participate in annual market gains – this debt strategy easily saves thousands & even millions in capital gains taxes.
4. Give to Charity
Today’s tax code is quite flexible when it comes to giving to charity - Current tax laws offer incentives to donors who contribute either cash or appreciated stock.
According to Forbes, Bill & Melinda Gates gave away a combined $50B since 1994. Apart from avoiding capital gains taxes, these gifts obviously constitute significant tax deductions.
How you can apply this principle
- We all have the ability to give SOMETHING to charity. Gifting appreciated stock is particularly tax-efficient given that it would deduct from Adjusted Gross Income while avoiding capital gains – a win on two fronts.
5. Maximize your Health Savings Account (HSA)
HSA accounts tend to fly under the radar. These are triple tax-advantaged accounts: Contributions are tax-deductible, assets grow tax free, & withdrawals are tax free for qualified medical expenses for those under 65 – those over 65 can withdraw for any purpose!
How you can apply this principle
- Include the HSA account in your broader portfolio allocation.
- Tailor asset types to further leverage all tax advantages (e.g., dividend stocks instead of growth, as dividends reinvested aren’t taxed)
Blame our Tax Code
Many assume the strategies of the world’s wealthiest are opaque, complicated, & perhaps downright corrupt. The reality is they often use everyday strategies we recommend to our clients!
It should be noted all strategies have inherent risks.
Holding cash might avoid drawdowns like those seen in stocks, but cash almost never sees positive returns due to inflation.
Conversely, stocks tend to beat inflation – but there certainly will be volatility along the way.
