The Top Tax Avoidance Methods Used by Wealthy Individuals

How Is It That Rich People Don't Pay Much Taxes?

We have always heard that the rich get richer. But how do they do it? They started creating their wealth, but is this the only way? In 2021, a news article published by ProPublica said that from 2014 to 2018, the 25 wealthiest people in the USA got rich by $401 billion. It further read that they paid only 3.4% of their net worth as income tax. How do billionaires pay such a minimal amount and can't get into the radar of tax officials? They do it legally as they don't evade taxes. Instead, they avoid taxes. Indeed, you are on the verge of becoming a Millionaire or billionaire and might wonder how the rich avoid taxes; here is a lot for you to know!

1. Depreciation helps in tax avoidance.

The rich people use depreciation to save on taxes. Depreciations allow rich people to recover the cost or basis of certain property for federal income tax purposes. According to a tax expert, Kelly Phillips Erb, depreciation starts in the first place when you put it in use and not when you start using it. The IRS considers property 'placed in service' when it is ready and available for use, not when you begin using it. It means you depreciate the cost of the item over its useful life unless there is some exception.

How to get the deduction?

You might be wondering how to get the depreciation deduction on your property. You can get this depreciation deduction on buildings, rental properties, machines, cars, furniture, patents, copyrights, and specific tangible and intangible software. However, you must fulfil the three essential criteria to get a depreciation deduction.

  1. The property must be used for a business or any income-generating activity.
  2. The ownership of the property should be in the name of claimants who want a deduction.
  3. Properties should have a useful life of more than one year.

The depreciation claims are made under section 179 of the federal tax return. In the year 2023, the maximum expense deduction is $1,160,000 for most of the properties.

2. Deduction for your expenses

If you have a business, then you can get great tax benefits. You can claim a potential tax deduction for some business expenses if you want to file taxes. You can get deductions for travel, vehicle, office supplies, work-related education expenses, a home office, etc. However, it is important to understand that only some individuals qualify for a legitimate business in the eyes of the IRS. IRS wants you to refrain from engaging in business without considering it your hobby. Understanding the differences between running a business and a hobby is important to get a legitimate deduction from your business.

How to get the deduction

IRS looks for many factors to consider and distinguish between a hobby that produces some income and a bonafide business. You must carry your hobby in a way such that it is a complete business for you. You must maintain full and accurate books and records.

  1. Put your whole time and effort into your hobby to make it more profitable.
  2. IRS look for your dependency on the income you generate from your hobby.
  3. They also look for your hobbies that make a profit and, if so, how much you earn from those profits.

3. Your kids can claim that deduction.

Many business owners turn small ventures into family businesses. If you are one of those who are considering hiring your kids to do your business work, then you can get potential tax benefits for it. If you have a sole proprietorship or partnership, you can employ your children under 18 years. This is because, according to the IRS, children who are under 18 years old and work for their parents in a trade or business are not subject to Social Security and Medicare taxes. Your kids can significantly help you claim those deductions if they do not exceed the standard deduction of $13,854 in tax year 2023. Another benefit of getting your children into your business is using their wages as business expenses.

How to get the deduction

Instead of paying high taxes on your business, you can transfer your income to your children as wages for the services they do. However, you must remember that your child must look legitimate, and their salary must be reasonable.

4. You Carry forward your business losses.

Every business is bound to some loss in a way; instead of crying about those losses, you can take advantage of them. You can carry forward the business losses you incurred in previous years. When businesses go down due to losses, it can result in negative taxable income as expenses exceed the revenue, this is how the NOL carry forward rule becomes relevant as it nullifies the positive taxable income. 

How to get the deduction

From the income tax year 2018 to 2020, the IRS permitted net operating loss carrybacks. Under this division, businesses experiencing an NOL could recover their loss for up to five years. So, for any reason, they could carry them forward if businesses generate losses.

5. Earn from investment

The major difference between rich and ordinary people is that they make their money work for them. They choose diversified investment options like real estate investment trusts and master limited partnerships that bring regular income to them. Rich people invest in stocks and real estate. However, it is important to understand that they make a significant investment at the beginning before they can start seeing their returns, and these returns are not guaranteed.

How to detect taxes

When you earn money, you pay 37% of it as taxes. Investing in stocks that pay out good dividends regularly lets you pay less taxes of 0%, 15%, or 20%, depending on your return and the tenure you have invested.

6. Sell the property you inherited

If you inherit a piece of property, you can minimise capital gain taxes by using a 'step-in basis'. To clarify, let us take an example. If you buy a plot for $200,000 and sell it for $450,000, you own taxes on a profit of $250,000. However, if you purchased land worth $200,000 and inherited it, you can use a step-in basis to reset it to the market value at the time of inheritance. If you sell the property immediately after inheritance, no capital gain tax is incurred on the profit of $250,000.

How to get a tax deduction

'Step up basis' is an automatic process. But if you try to get the property before your parents die, then they will end up with hefty taxes, eventually refraining the advantages you were receiving financially.

7. By whole life insurance

Insurance's main aim is to protect your dependent if you die. However, life insurance is not just insurance but an investment policy for you and your family. This is how the rich avoid taxes while taking whole life insurance.

How to get the deduction

Whole life insurance provides an advantage as policyholders get tax-deferred growth. However, under some conditions, they even receive tax-free distributions. Hear the policyholder receive a double benefit when transferring their benefits to their beneficiary, who gets the entire amount without obligating any tax. You can even consult a qualified financial planner or insurance agent to receive and get expert tips on saving taxes on Life insurance.

8. By yourself, a yacht, or a second home

Many people need cash to buy a boat or second home, but rich people stand out because they have multiple residences and benefit from reducing the tax burden.

How to get the deduction

If you own a house and use it for deduction, you only deduct the property taxes. On the other hand, you also pay mortgages. The best part is taxpayers can deduct up to $10,000 for property taxes. If you buy a second home, you can deduct your property's taxes and mortgage interest. The IRS considers a yacht as a home as it includes sleeping quarters, a kitchen and a toilet. If you can't afford the second home, the expensive one is even out of reach.

9. Open a health savings account.

A health savings account is a tax-deferred account that covers health care expenses. However, it also gives the benefit of avoiding taxes if you use it properly. Any contribution you make to a health savings account is tax deductible. Even the earnings you earn from that account are tax-free. If you spend the amount in a health service account for non-healthcare expenses, you pay a 20% penalty. However, a tax-savvy approach is that after you turn 65, you can withdraw your HSA amount for any other purpose without penalty; however, if you use that money on non-health expenses, you still owe ordinary income tax.

How to get the deduction

First, open an HSA and make regular contributions; however, it is essential to understand that they are not available to all taxpayers, and therefore, you need to participate in a high-deductible medical insurance plan. You can only contribute $3,854 per individual for $7,754 in family coverage.

Bottom Line

By going through the article above, you now better know how the rich avoid taxes. By implementing all these strategies, you can also avoid taxes, save plenty of money, and utilise it by investing in other investment vehicles. Rich people avoid taxes and make their money work for themselves to earn more. Take advantage of a single chance to evade taxes, as it is not illegal. Instead, many sections are specifically designed for people to reduce the tax burden. However, remember there is a fine line between tax evasion and tax avoidance.

Read Also:

  1. How to save money each month

  2. How to make passive income

  3. How to deal with Financial Worries

  4. How to save money for Child

21 Jan, 2024

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