Mitt Romney's Sweetest Tax Break: The Dirty Little Secret of Carried Interest

"Oh, I'm sure people will talk about it," GOP presidential hopeful Mitt Romney told a Florida audience Monday night, on the eve of the much-ballyhooed release of his tax returns. "But -- but I pay all the taxes that are legally required and not a dollar more."

And as Romney's returns showed, that was absolutely the truth -- the former Massachusetts governor pays all the taxes that are legally required ... and not a dollar more. The surprise for many voters, however, will not be not that Romney's taxes are in order, but just how small a percentage of his income goes to Washington.

According to his returns, Romney made $21.6 million in 2010, and paid a little over $3 million in taxes. This works out to 13.9% of his income. By comparison, the average U.S. household making $79,000 pays an effective income tax rate (income tax minus deductions) of 14.4%. In other words, Romney's 2010 tax percentage was lower than that of a family making 0.3% of his income.

How did Romney manage to pay taxes at such a low rate? The "secret formula" isn't so secret: It's just out of reach for most Americans. Romney's money came from investments, not wages. Under the current tax code, anyone with a salary of $379,150 or more per year pays taxes on it a 35% tax rate. However, people who derive their income from stock dividends, capital gains or carried interest only pay 15%. Those three categories account for the vast majority of Romney's income.

There's a case to be made for taxing capital gains and dividends at lower rates. It goes something like this: Invested money was taxed when it was first earned, and corporations pay taxes on their profits. From this perspective, taxing dividends and capital gains is like taxing the same money a third time.

Other pundits and tax critics claim that investment tax breaks are good for the economy, as they encourage people to keep money in the market, where it helps fund startups, business expansion, and other economically worthwhile endeavors.

It's Not What You Think

But a big chunk of Romney's income doesn't come from stocks that he personally holds. In 2010, he made $7.4 million from carried interest.

You haven't heard of carried interest? Basically, it's a share of investment income that goes to the private equity manager who oversaw the investment. Romney's carried interest income doesn't come from dividends on stock he owns, nor from the sale of stock that he once owned. The money wasn't generated from income that he had already paid tax on. Think of it as being sort of like a tip skimmed off the top of all the money that his company makes for its investors.

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But unlike tips for a waitress or cabbie, which are taxed at the same rate as wages, Romney's carried interest income is taxed at the same 15% rate as other investments. The discounted carried interest tax rate -- which is moderately controversial, but would be probably be seriously controversial if more people understood it -- has come under heavy attack in recent years, but is still in effect.

A few moments after announcing the release of his tax returns, Romney told his audience that "I'd like to see our tax rate come down." His leading Republican opponent, Newt Gingrich, agreed, noting that "I'd like to bring everybody else down to Mitt's rate, not try to bring him up to some other rate." He went on to announce that, if he were in the White House, the tax rate on capital gains would be zero.

It only took a second for Romney to understand the implications of Gingrich's tax proposal: "Under that plan, I'd have paid no taxes in the last two years!"

Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.