Warren Buffett is the Oracle of Omaha. He exudes a very button-downed, no frills persona – still living in the same home that he bought for $31,500 more than 50 years ago. Over the years, he has amassed a fortune estimated at $35-$40 billion dollars. Buffett is an extremely skilled investor. His company, Berkshire Hathaway, has its hand in just about everything, owning some companies outright and holding substantial shares of others. Companies that Berkshire Hathaway has a significant piece of include GEICO, Pampered Chef, Helzberg Diamonds, Coca-Cola, Kraft, Wells Fargo, and Fruit of the Loom.
When Wile E. Coyote purchases building supplies, he goes to Acme Building Supplies. Who owns Acme? Berkshire Hathaway, of course. Stay out of my cartoons, Warren Buffet!
Nearly all of Warren Buffett’s income comes from capital gains. When he pays taxes on these gains, the tax rate is 15%. However, Buffett certainly had deductions (such as charitable contributions) that drive his effective tax rate even lower.
In contrast to the low key, buttoned down image of the Oracle of Omaha, Jimmy Buffett is the poster child for the party lifestyle. Buffett’s home base is in Key West, and his music fits the locale. The recurrent themes of escaping from the pressures of life and just relaxing strike a chord with millions of devoted fans who refer to themselves as Parrotheads. Many of his songs are just as relevant today as they were more than thirty years ago, and Buffett is a coveted collaborator, sharing the stages with the likes of The Eagles, the Zac Brown band, and Alan Jackson.
Jimmy Buffett has brought pleasure to millions of fans over the years. In addition to his songs, he has dabbled in writing – joining former Key West resident Ernest Hemingway and a handful of other authors who have hit #1 in both the fiction and non-fiction best-seller list.
Jimmy has also entered into a variety of licensing rights over the years. Across the country, you can find a number of Buffett-themed restaurants and casinos.
When Jimmy Buffet pays taxes on his touring revenue, album royalties, and licensing deals, it’s getting taxes at a rate of 35% – taking a bit of the spark out of Jimmy’s party.
On a number of occasions, Warren Buffett noted that his effective tax rate was less than his secretary’s. This has even attracted the attention of President Barack Obama who has proposed a tax plan called the Buffett Rule designed specifically to fix this tax inequality.
Ever wonder why Steve Jobs worked for a salary of $1 a year? Here’s a hint… it wasn’t because he was nice. It’s because he got his compensation in the form of stock and stock options. He knew that he could manage this type of income to pay less in taxes.
The Middle Class and Effective vs. Marginal Tax
Many middle-class Americans may be looking at the 14% number and thinking to themselves, “But I pay 25% in income taxes and I’m not making millions. Something is wrong.” Those people are right, a couple of things are wrong. First, many are not paying the 25% that they think they are. Many look at the tax brackets like this one for 2012 tax year (as a single filer):
- 10% on taxable income of $0 to $8,700
- 15% on taxable income of $8,700 to $35,350
- 25% on taxable income of $35,350 to $85,650
- 28% on taxable income of $85,650 to $178,650
- 33% on taxable income of $178,650 to $388,350
- 35% on taxable income over $388,350
… and make the mistake of thinking, “I make $50,000 a year, so I pay 25% in income tax.” Some will even try to find some last minute tax deductions to try to get under that $35,350 mark in an attempt to save big on taxes. Fortunately, that’s not how it works. Kosmo at The Soap Boxers explains how marginal and effective rates work. The person earning $50,000 of taxable income actually pays at each level. This breaks down to $870 at the 10% bracket, $3997.50 at the 15% and $3662.50 at the 25% bracket for a grand total of $8,530 in actually tax owed. This is an effective tax rate of around 17%, not the 25% that some expect.
Additionally, it is worth looking at the $50,000 taxable income number. Many people who make a $50,000 salary are able to reduce their taxable income number through deductions and programs like 401k plans.
The Tax Code is the Problem
Why are capital gains taxed at such a low rate? The basic idea is that there is more risk in equity investing than in investment vehicles such as passbook savings accounts. Some startups go the path of Apple, Google, and Facebook, but some startups are Lazy Man’s Beantown Hummus. (Let’s not talk about that business venture. ;-).) Thus, in order to ensure that people are stimulated to invest in startups, capital gains are taxed at a lower rate.
OK, I’ll buy into that. Tax capital gains at a somewhat lower rate than ordinary income. But ratchet the capital gains rate up a bit. The rates for ordinary income are progressive; why not have brackets for capital gains instead. Maybe a $50,000 capital gain is taxed at 15% but a $50 million gain is taxed at 25% or 30%. If you make that change, you’ve increase tax revenue by $5-7.5 million while still allowing the capital gain to be taxed at a lower rate than ordinary income.
Even if the person making $50,000 in taxable income isn’t paying 25%, it still seems wrong that billionaires can pay 15% on dozens of millions of dollars and an average Joe (not necessarily Joe the Plumber) is paying 17% on his ordinary income.
That’s a raw deal and it isn’t going unnoticed.
How to Pay Less in Taxes
It’s going to take an act of Congress to change the inequity between ordinary income and capital gains. Bear this in mind when you head to the polls in November. However, there are steps you can take to reduce your taxes:
- Earn less money–Less income means you pay less in taxes! (OK, this is actually a really terrible idea. Don’t cut off your nose to spite your face.)
- Take all your deductions– Don’t leave any money on the table. Take all the deductions you are legally entitled to. If you normally take the standard deduction, check to make sure it doesn’t make sense to itemize. If your life situation has changed substantially (buying a house is a great example), this can make a huge difference between taking the standard deduction or the itemized deduction.
- Donate your crap–Still have that leisure suit that was actually in style once upon a time? Vinyl albums from the days when you had a record player and books from the pre-Kindle days? Donate them and you’ll get a tax write-off (assuming that you itemize). Added bonus? The items will actually be used by someone, instead of gathering dust in your attic.
- Tax advantaged accounts– If you pay for day care, you can take advantage of a flex spending account for this expense. Medical expenses have more possibilities. Flex spending accounts for eligible medical expenses are relatively common, and you may also have the option of a health savings account (HSA) or health reimbursement account (HRA). These accounts all allow you to pay for expenses with pre-tax money.
- Time your expenses – If you have some deductible items that are due to be paid in January, write the check in December. The most common case is with mortgages – paying the January payment in December results in a larger interest expense in the current year. In general, this is a case of robbing Peter to pay Paul, as it will reduce that expense in the next year (since there is no January payment). However, if you’re right near the cutoff of standard deduction vs. itemized deductions, it might save you money to itemize in the current year and take the standard deduction the next. It also makes sense to pull as many deductions in the current year if you expect to be in a lower tax bracket next year (if you are retiring, for example).
- Contribute to a 401(k) – There’s plenty of debate about the decision of whether a Roth or 401(k) is the better option, which much of the decision based on your projected future tax rate. However, one thing that’s for sure is that contributing to a 401(k) will reduce this year’s tax bill.
Continue to Never Settle for Less by Filing online at H&R Block or in an H&R Block Office.
Though this article was sponsored by H&R Block, H&R Block did not supply any of content for the article. The article’s ideas/opinions are Lazy Man and Money’s and not H&R Block’s.