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With one of the hot election topics in the U.S. being increased taxing of the so-called "rich" (those with a household income > $250,000), I'm curious about the options such households have for reducing their tax bills. I am aware of the following deductions:

  1. 401(k) workplace contributions. Unfortunately, IRA deductions phase out.
  2. College 529 plans for dependents.
  3. Real estate mortgage interest.
  4. Losses (be it in sale of stocks, real estate, gambling, etc.)

What other deductions exist that the "rich" take advantage of considerably?

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I removed the last paragraph of your question, about debating the unfairness of the definition of "rich", as it could've led to extended debate/discussion. This is not a discussion forum, but a place to get specific questions answered. –  Chris W. Rea Nov 29 '12 at 14:11
    
401(k) workplace contributions are also limited. –  Dilip Sarwate Nov 29 '12 at 15:11
    
I removed the line referencing a $2500 limit for the 529 account. As noted in my answer, the limit is far higher. –  JoeTaxpayer Nov 29 '12 at 19:19
    
I actually should have clarified that $2500 is the maximum deduction you can avail –  rs79 Nov 30 '12 at 16:21
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It is really difficult to answer this, because we have no idea about your specific situation. Could you give more specifics? What are you concerned about, e.g. being subject to AMT? Or describe what you would like to do but don't know if it would help, e.g. purchase a second property for investment purposes, and whether it would be tax deductible, that sort of thing. –  Ellie Kesselman Dec 4 '12 at 15:04

5 Answers 5

up vote 20 down vote accepted

You're asking explicitly about $250K+ wage earners. Well, believe it or not, but this is the most discriminated group of people in the US tax code. This is what is called "the upper middle class". People who still have to work for a living, but treated as if they're rich (I don't consider people who must work to keep up their life style as rich).

Many of the deductions cannot be taken by them. Lets go over the list Keith made:

  1. Charitable contributions: While it is true that you can deduct those (up to a certain limit, no more than 50% of your income), you cannot deduct "contributions" where you get something in return. You can calculate the difference and deduct the portion for which you didn't get anything in return, of course, but it will be a nasty audit.
  2. 401K is limited, this year - no more than 17K. If 401k is available - IRA is not. If 401K is not available - IRA is still not available for high earners (unless the employer doesn't provide a retirement plan for neither of the spouses, highly unlikely at these levels). Either way, $250K+ wage earners can probably deduct no more than you and me on retirement savings.
  3. Meals and entertainment is a huge red flag for the IRS, they're just waiting for you to claim it to go after you with a nasty audit. As a wage earner, you cannot claim that.
  4. Business expenses - those are limited, and heavily audited. You can deduct some of the expenses the employer hasn't reimbursed you for, but only above the 2% AGI threshold. So, first $5K at least (for a $250K earner) are non-deductible.
  5. Health insurance can be pre-tax only through employer, not self-paid premiums. Health expenses deduction on schedule A is only for expenses in excess of 7.5% of the AGI (10% going forward). First 25K is non-deductible, all the rest are going to be heavily audited as this is another red flag.
  6. Mortgage interest is limited to 1 million of mortgage, and only for a primary residence. Multiple primary residences? Doesn't really matter, the 1M limit stays. If there's no change in the law, it will also be phasing out for high earners, limiting it even further.

You mentioned losses - you cannot deduct gambling losses (in excess of gambling income), and you cannot deduct passive (rental real estate, for example) losses. While for rental real estate there's a small amount of losses you could deduct, it phases out well below the $250K line (can be deducted against passive income, or when disposed of the property). 529 plans are not deductible (in fact, its a gift subject to the gift tax).

Bottom line, being a high earner with wages only means you pay the most tax. You either find a way to become self employed and have a lot of business deductions on your schedule C/1120S, or switch to capital gains. You can marry an unemployed partner, it will make your life slightly easier.

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Good job, @littleadv. The only fact-check is the IRA. If a high earner employer has no 401(k) at all, the IRA becomes a deduction. This is so rare that it applies to very few, I suppose. And, agreed, the real estate losses for the $150K+ earner simply carries forward until there are profits to negate or a sale, in which case they become available. WRT to Keith, major red flags for audit. –  JoeTaxpayer Nov 29 '12 at 21:16
    
+1 for writing a factually correct answer. –  Dilip Sarwate Nov 29 '12 at 23:06
    
@Joe, you're right, clarified that point –  littleadv Nov 29 '12 at 23:15
    
The 401K contribution is 17K per person, plus 5K more if they are 50 or over. If both spouses work they can save twice as much. Also 529 plans can be deductible on state taxes. I believe the 529 limit is per beneficiary per contributor. –  mhoran_psprep Nov 29 '12 at 23:40
    
@mhoran_psprep in 2012 the age 50 catch up extra is $5500. Minor difference. –  JoeTaxpayer Nov 30 '12 at 2:43

One of the main tax loopholes more readily available to the wealthy in the U.S. is the fact that long-term capital gains are taxed at a much lower rate. Certainly, people making less than $250,000/year can take advantage of this as well, but the fact is that people making, say, $60,000/year likely have a much smaller proportion of their income available to invest in, say, indexed mutual funds or ETFs. You may wish to read Wikipedia's article on capital gains tax in the United States.

You can certainly make the argument that the preferential tax rate on capital gains is appropriate, and the Wikipedia article points out a number of these. Nevertheless, this is one of the main mechanisms whereby people with higher wealth in the U.S. typically leverage the tax code to their advantage.

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Suggested correction to that last sentence: This is a mechanism whereby people with higher wealth (instead of income) leverage the tax code to their advantage. True, I'm sure a lot of high income earners take advantage of it too, but the best benefit is for those with more investment income than earned income. Also, I'd debate the characterization of this as a loophole since it is an intentional tax policy to encourage investment and not an oversight in the tax code that you can use for tax avoidance. –  JohnFx Nov 29 '12 at 16:21
    
Good points, John. The tax treatment of capital gains certainly benefits wealth vs income, but what makes the news are the money men whose business results in what you or I would consider income which is treated as capital gains. I agree, we can debate whether this treatment is simply our tax code as intended, or loophole. (I believe this is the distinction, loophole referencing tax treatment that wasn't really intended, such as the "back door" Roth IRA maneuver. –  JoeTaxpayer Nov 29 '12 at 16:53
    
Thank you, I have made the change suggested. I think you can edit my answer, and I certainly encourage you to do so if you have any other changes. Whether or not this is a tax loophole is certainly open to debate. I use it myself (in Canada) and am not trying to pass any sort of moral judgment here. :) –  ChrisInEdmonton Nov 29 '12 at 17:30
    
the question was about deductions on whatever your tax bill is, not what your tax bill is. so regardless of what the rate is, the deductions will be used to lower it. So if you start at max 15% for long term capital gains (instead of say 30% for income) then you start deducting from there to get it even lower, closer to single digits. Thats what this thread is about –  CQM Nov 30 '12 at 0:24
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@CQM - Are you saying that the rate on Long Term Cap gains is what it is and not a deduction? That it's tangent to the thread? Put that way, I agree, while at the same time, even though not a 'deduction' it sure is a strategy used by rich. –  JoeTaxpayer Nov 30 '12 at 17:19

The $250K and up are not one homogeneous group. The lower end of this group benefits from normal Schedule A itemized deductions, e.g. mortgage interest, property tax, state income tax, and charitable donations. As you mention, 401(k) ($17k employee contribution limit this year), but also things like the dependent care account ($5k limit) and flexible spending account, limited usually up to $2500 in '13.

The 529 deposits are limited to the gifting limit, $14K in 2014, but one can gift up to five years' deposits up front. This isn't a tax deduction, but does pull money out of one's estate and lets it grow tax free similar to a Roth IRA. The savings from such accounts is probably in the $15k - $20K range given the 20 or so year lifetime of the account and limited deposits.

At the higher end, the folks making the news are those whose income is all considered capital gains. This applies both to hedge fund managers as well as CEOs whose compensation included large blocks of stock. This isn't a tax deduction, but it's how our system works, the taxation of capital gains vs. ordinary income.

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It might be worth noting that capital gains, in addition to being taxed at a lower rate, can often be deferred (sometimes for decades). Since assets that would otherwise have belonged to the government can continue to grow in value, the effective tax rate can be significantly lower than the "quoted" (for lack of a better term) tax rate. –  psr Nov 29 '12 at 18:27
    
How does one defer capital gains? One can have unrealized capital gains but capital gains are taxed when realized. –  Dilip Sarwate Nov 29 '12 at 21:21
    
@DilipSarwate - I think it's just a matter of phrasing, you are correct, to be precise, it's 'unrealized.' I suppose I can say I'm sitting on a capital gain, but I'll agree with you, it's not a gain until the sale is made. –  JoeTaxpayer Nov 29 '12 at 21:43
    
Actually, my comment was directed at @psr who claimed that "... capital gains .... can often be deferred (sometimes for decades)", not at you. –  Dilip Sarwate Nov 29 '12 at 22:51
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@mhoran_psprep Yes, but subject to various rules which I won't describe in detail (interested parties can consult Publication 523), up to $250K ($500K for married filing jointly) of the capital gain can be excluded from tax once every two years. For many (probably most) people, this is equivalent to no tax on the capital gains realized from selling a residence. –  Dilip Sarwate Nov 30 '12 at 2:26

From Rich Dad, Poor Dad. 3 Major Things:

  • Business Expenses
  • Real Estate

With rental real estate, in addition to mortgage interest, you also deduct property taxes, and must claim depreciation (cost of house / 27.5 years)


Business Expenses. For example, buy a yacht and put it in a charter fleet. Deduct interest on the loan, depreciation of the asset, property taxes, upkeep of the boat. Your "business" earns profit from chartering the boat, which if I recall correctly is taxed at a lower rate. You get to go sailing for free.

Then there was the concept of subdividing the businesses. If you own a restaurant, create another business to own the property, and the equipment used in the company. Then lease the equipment and rent the land to the restaurant. Now admittedly I thought this was like the Daylight Savings plan of tax avoidance, I mean now aren't you essentially having two companies paying half the taxes. I am sure there are well paid CPAs that make the math happen, perhaps using insurance plans.. Perhaps each business funds a "whole life" insurance account, and contributes vast amounts into that. Then you take a loan from your insurance account. Loans of course are not income, so not taxed.


The third way is to create your own bank. Banks are required to have reserves of 9%. Meaning if I have $100 dollars, the FDIA allows me to loan $1,111. I then charge you 20% interest, or $222/yr. Now how much can I loan? ...well you can see how profitable that is. Sure you pay taxes, but when you print your own money who cares?

Most of this is just gleamed from books, and government publications, but that was my general understanding of it. Feel free to correct the finer points.

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As was stated, households earning over $250k/yr don't all get their income one way. Below that threshold, even in the six figure range, most households are in one of two categories; salary/wage/commission workers, and those living off of nest eggs/entitlements (retired, disabled, welfare). Above $250k, though, are a lot of disparate types of incomes:

  • High-end salary workers
  • Self-employed/small business owners
  • Corporate entities (LLCs, PCs, S-Corps, C-Corps)
  • Investors
  • Executives (paid heavily in stock, making them "investors" in the company).

Now, you specifically mentioned wage earners above $250k. Wage earners typically have the same "tax havens" that most of us do; the difference is usually that they are better able to make use of them:

  • Mortgage interest/property tax deduction (at >$250k, you may well have multiple homes that count as "residences"; a mortgage is one thing you should think carefully about before paying off early)
  • Retirement accounts (IRA/401k; a high-end wage earner will contribute as much as they are allowed to as many plans as are available)
  • Charitable donations (a lot of the things you can donate to will benefit you by reciprocity; donating to support a day care at your church, or at the other end a hospice or assisted living run by a FBO, may get you free child or elderly care, for instance. The entire donation is then tax-deductible, instead of a cap of $5k on a dependent care FSA)
  • Medical expenses:
    • Health insurance premiums. Low-deductible, low-copay "Cadillac" plans cost a lot, but they're pre-tax and can cost you a lot less than footing the bills yourself if you make use of them. This is largely going away; a considerable excise tax is going to be levied under Obamacare on plans with premiums over a certain annual amount.
    • Non-covered deductible medical expenses. Anything insurance doesn't pay for that is "medically necessary" in the opinion of your doctor is tax-deductible. Did you know that if you get a doctor's note, a massage and facial at a day spa can be completely written off as treating muscle aches and skin conditions?
  • Business expenses, IF the structure of your employment allows you to claim Schedule C, which typically requires contract/freelance work:
    • A lunch with a co-worker in which something related to work is discussed is a "business lunch" and you can deduct half of it.
    • Plane tickets to that conference in Vegas (and the hotel stay) can be at least partially written off (not sure if you can only deduct the base cost of an economy seat or if you can deduct the full first-class ticket).
    • "Entertaining clients" is a very well-known (infamous, you might say) way to write off a round of golf, or tickets to a sporting event, or a few grand in table dances at a strip club. As noted in the comments, the IRS looks much more closely at these types of expenses than they used to.
    • If you drive your own car to anything during the work day for purposes of conducting business, you can take 33 cents a mile, or actual costs if you can prove them, off your income (and that can add up very quickly if you spend your day showing houses or the like). Remember that business lunch? Kick in an extra few dollars driving there and back.

In other words, there are many ways for a high-end wage earner to live the good life and write a lot of it off.

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Interesting answer. A quid pro quo of service for donation loses the deduction, same as when one donates at a charity auction, they deduct what is in excess of fair market value only. IRS is cracking down on entertainment, I believe that stripper table dances won't pass an audit. –  JoeTaxpayer Nov 29 '12 at 19:00
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It appears that you've listed almost all of the frauds people do. It seems to me that none of what you listed is a valid deduction. Many are red-flags that would trigger audits. –  littleadv Nov 29 '12 at 20:24
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@Keith - but that is for a business owner, not a salaried employee. You're confusing schedule A and schedule C expenses. The OP explicitly asked about salaried employees, none of your examples fit that. –  littleadv Nov 29 '12 at 21:12
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@KeithS Contractor is not a wage earner. There's a big difference both for the contractor and the employer. Many times IRS are auditing employers in order to uncover employees being paid as "contractors" while being de-facto employees. Since the chances of an audit for a corporation are significantly higher than for an individual, these tricks should be avoided. If you're talking about a genuine contractor - then it is a self-employed business owner, not a salaried employee. Business execs, especially corp officers, must be employees. –  littleadv Nov 30 '12 at 0:18
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No keith, that's not the only difference. If that's the only difference, your employer is breaking the law. I'm not saying that there aren't employers just falling between the chairs and not getting caught, but IRS actually does have a strict set of yes/no questions that differentiates the two, and specifically for corporation officers - they're employees by definition and corporations are being audited on that. Here's some material from the IRS on the matter: irs.gov/pub/irs-utl/emporind.pdf –  littleadv Nov 30 '12 at 2:53

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