What are the common income tax deductions used by “rich” salaried households?

Question

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?

Answer 1

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.

Answer 2

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.

Answer 3

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 $5k, dropping to $2500 in '13.

The 529 deposits are limited to the gifting limit, $13K in 2012, 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.

Answer 4

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.