Ways the Middle Class Is Taxed Differently Than the Rich
In America, it’s almost always better to have more money than less, but it’s especially nice to be rich during tax season.
“The wealthy often have opportunities for tax savings that are not readily available to the middle class,” said former Wells Fargo financial advisor Jonathan Feniak, general counsel of financial and tax strategies and head of finance at LLC Attorney.
Bigger bank accounts aren’t the only thing that separates the monied class from the masses. The IRS has a much heavier hand with one group than the other.
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When Money Makes Money, the IRS Takes Less
Generally speaking, the rich earn most of their income through capital gains and the middle class earns most of its income by exchanging labor for money — also known as working for a living.
According to a 2023 Brookings Institute report, “Investments and businesses constituted 82% of income for the top 0.01% and 88% for the top 0.001% in the most recent data, compared to just 7% for the bottom 80% of households.”
This is an important distinction because the IRS takes a bigger share of money earned from work than money earned through investing.
“Their large capital gains allow them to benefit from a reduced long-term capital gains tax rate, which is generally lower than income tax rates,” Feniak said.
Brookings sums it up this way: “Wages face heavier taxation than capital income, even though wages go mainly to low- and middle-income households and capital income goes mainly to high-income households. As a result, the tax share of income paid by the very highest-income households is often lower than for middle-class households.”
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When People Make Money, the IRS Takes More
In a 2023 research report titled, “The Limits of Taxing the Rich,” the Manhattan Institute wrote, “Capital gains are overwhelmingly tilted up the income ladder, with 75% of all long-term capital gains reported by the richest 1%, and 85% of capital gains reported by the top 5%.”
“On the other hand, the middle class primarily earns through wages, which are subject to higher income tax rates,” Feniak said.
The IRS taxes long-term capital gains on a graduated scale that maxes out at 20%. That means even the richest households can pay no more than one dollar in five on their capital gains.
However, if the investment returns that the rich rely on were taxed as ordinary income or if they worked for most of their money like the middle class, they would have to forfeit not 20%, but 37% of their earnings to the IRS as members of the highest tax bracket. Effectively, the rich get a tax break of nearly 50% by not working for most of their income.
Mountains of Unrealized Gains Let the Rich Buy, Borrow and Die Without Ever Meeting the Tax Man
According to Americans for Tax Fairness, “While most Americans predominantly live off the income they earn from a job — income that is taxed all year, every year — the very richest households live lavishly off capital gains that may never be taxed.”
Here’s how it works.
Wages and short-term capital gains are taxed as ordinary income at a higher rate. Long-term capital gains are taxed at a lower rate. But investments aren’t taxed at all until you sell them and until you do, the returns they earn are called unrealized gains.
Who Needs To Sell Investments Once When You Can Borrow Against Them Forever?
According to Federal Reserve data, America’s billionaires and centi-millionaires (those worth at least $100 million) collectively own $8.5 trillion in untaxed income held in unrealized gains.
But they can’t access that wealth until they sell their holdings, at which point they will be taxed, right? There you go, thinking like a middle-class wage earner.
According to Forbes, the ultra-rich use a strategy dubbed “buy, borrow and die” to live the lavish lifestyle their massive stores of unrealized gains would provide if they cashed them out and paid taxes on them without having to do either.
Instead, they take out flexible, low-cost, easy-approval loans called Securities Backed Lines of Credit (SBLOCs) against their holdings to finance their lifestyles. When they die, they receive a step-up in cost-basis, which allows their heirs to sell enough stock to cover the loans without paying capital gains taxes and then repeat the process.
On the other hand, middle-class investors have most of their holdings tied up in retirement accounts, which they pay taxes on either before they contribute — Roth accounts — or when they take distributions, as with 401(k)s and IRAs.
Death Is Certain; Taxes, Not So Much
Benjamin Franklin famously said, “Nothing is certain but death and taxes.” But the rich are masters at using the former to avoid the latter.
“The affluent usually have access to sophisticated tax advisors who can help them leverage tax deferral strategies, such as using trusts or complex estate planning,” Feniak said.
For example, a ProPublica report exposed how some of America’s richest billionaires use Grantor Retained Annuity Trusts (GRATs) to avoid being taxed on generational wealth transfers.
It wrote, “A typical GRAT entails putting assets, like stocks, in a trust that ultimately benefits a person’s heirs. The trust pays back an amount equal to what the trust’s creator put in plus a modest amount of interest. But any gains on the investments above that amount flow to the heirs free of gift or estate taxes. So if a person puts $100 million worth of stock in a GRAT and the stock rises in value to $130 million, their heirs would receive about $30 million tax-free.”
The middle class, on the other hand, pay taxes their whole lives and, most often, again after they die.
According to PlannedGiving, nearly seven in 10 Americans don’t have even a basic will, much less trusts or complex estate planning measures in place to protect their heirs, ensure their assets are handed down according to their wishes and, of course, to minimize taxes.
“Their access to tax-lowering strategies is often more limited due to the cost and complexity of tax planning services,” Feniak said.
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This article originally appeared on GOBankingRates.com: Ways the Middle Class Is Taxed Differently Than the Rich
