Thursday, December 6, 2012

How the rich will avoid taxes

Suppose the worst happens. Congress and the President go over the Fiscal Cliff. You are one of the fortunate 2% people whose income is over $250,000. Someone like, Mr. Buffet for example. How do you think he might deal with the new tax scenario?

Let's take a pool of money, say $500,000 and invest it in a stock portfolio. Qualified dividends are taxed at the rate of 15% right now, until January 1st, when they will go up to ordinary income rates. So, if you are in the highest tax bracket of 39.6%, plus the additional taxes added because of Obama Care, then you are going to 44.7%. Do you really believe that wealthy investors are just going to sit there and not shift their income around?

The capital gains tax rate will go from 15% to a modest increase of 20%. This is significantly lower than 44.7%. Quit a bit lower in fact. Instead of taking dividend income, these investors will simply sell something and pay the 20% capital gains rate, if they have a profit. Most often, they will simply sell their losers and not pay any taxes. Either way, 20% or 0% is a whole lot better than 44.7%.

In a little different tax reduction strategy, people like Mr. Buffet will simply reduce their portfolio of dividend paying stocks to companies who pay little or no dividends.

Let's continue with my example portfolio of $500,000. Keep in mind, that for my example purposes, my investor is in the top tax bracket of 44.7% after January 1st. Suppose my investor's collection of dividend paying stocks paid an overall yield of 3%. This investor's $15,000 of income would owe taxes of $6,705 in the 44.7% tax bracket. Now, consider if they reduce their dividend paying stocks down so that their yield is 1.5% instead of 3%. The taxes owed would drop to $3,352.50. This represents a 50% tax savings.

Further still, what if the investor shifted some of their funds to tax free and AMT tax free municipal bonds? They might be able to eliminate their taxes on dividends altogether. If they are able to limit or eliminate their taxes altogether, then they may be able to do this so that they drop down into even a lower tax bracket.

Another strategy that is tailored for those who need high income with low taxes on that income is to use a Multi-Split Annuity strategy. Instead of investing the $500,000 in dividend paying stocks, you purchase three annuities. One has a 5 year certain payout and the other has a 5 year deferral, then a 5 year certain payout. The other is a deferred annuity that grows for 10 years back to the original principal amount.

The first immediate annuity pays $2,300 a month for 5 years and 87% of it is tax free. You only pay taxes on $299 a month which is 13% of the $2,300.

The second immediate annuity pays $2,600 a month for 5 years beginning after the 5 years of deferral and is 65% tax free. You only pay taxes on $910 a month which is 35% of the $2,600.

The third deferred annuity which is deferred for 10 years starts out at $279,200, but grows back to the original $500,000 that you started with at the beginning of this strategy. The growth of this annuity is tax deferred so there are no taxes due over the 10 year period.

Crunching the numbers we find that for the first five years we had to pay taxes on $17,940 of taxable income. This is on $500,000 of principal, keep in mind. Even in the 44.7% bracket, this is only $8,019.18, but we received $138.000 ($2,300 per month) during this first 5 years. This is a 5.52% yield by the way.

Then, on the next five years, years six through ten, we pay taxes on $54,600. At the 44.7% bracket, this is $24,406.20 in taxes due. However, we received $156,000 in income and our yield has grown to 6.24%.

The total tax rate paid during this 10 year period was 6.49%. This is a whole lot better than 44.7%, wouldn't you agree? It is also better than a 20% capital gains tax rate, too.

Note: This is an example of a Multi-Split Annuity strategy. The actual numbers vary according to interest rates, payout rates, age and tax brackets. A Multi-Split Annuity strategy works better in higher interest rate environments. This is not meant to be tax, insurance or financial advice on a Multi-Split Annuity strategy, but rather simply an example of how sophisticated investors might avoid income taxes.

These are some limited examples of what the rich will do to reduce their income taxes. Like I said, Congress and the President are not going to get the money they think they are from the rich. Oh by the way, they are well aware of this, too. This is just all an issue of fairness. The President believes that the rich need to pay their fair share. He campaigned on it, got elected on it and now he is demanding it from the House of Representatives.

Neither Congress or the President truly care about getting extra revenue from the rich, because they know the rich will rearrange their portfolios to reduce their taxable income. This is all about politics and who ends up getting the blame. Sadly, the American people are the pawns of this chess game. Let's hope somebody in Washington D.C. will come to their senses and do something for the American people, instead of their own political agenda.