How the Wealthy Avoid Taxes (and how You Can, Too)

In this episode of Friends Talk Financial Planning, we talk about some ways that the wealthy use to pay less taxes. Whether or not you have millions of dollars in the bank, these strategies could still help you lower your tax bill in the future!

Resources:

- Alliance of Comprehensive Planners: https://www.acplanners.org

- John's firm website: https://www.trinfin.com

- Find us on Facebook: https://www.facebook.com/friendstalkfinancialplanning

TRANSCRIPT:

Bridget: Well, you can depreciate the building. So that means if it costs $100,000, you can depreciate it over 27 and a half years. That means you can take a chunk of that every year. And while most of the time real estate's going up in value, even though the value of it is going up, you get to take some of that as an expense every year.

John, a lot of people think rich people don’t pay taxes; they avoid them. On this episode of Friends Talk Financial Planning, we’re going to talk about how the wealthy avoid taxes and how you can too. Hi, I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.

John: I’m John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Before we jump into how to avoid taxes like the wealthy do, I want to remind everybody to hit that subscribe button and like this video on YouTube. That helps other people find this information. And with that, I’m looking forward to digging into this topic, Bridget. We hear a lot of people, say, “The wealthy don't pay taxes.” We've got some clients who are fairly wealthy, and I can tell you they do pay taxes, but they do also use some hacks, as you will, to minimize those things.

Bridget: Right. So some strategies. Let's talk about one that we have and that is have stock and hold on to it until you die because then it gets a step-up in basis. And we have a wealthy Chicagoan. I don't know if this is true or not, but some people say that this is the strategy that this was family was engaging. And that person is Virginia McCaskey who was George Hallas’s daughter, and she inherited the Bears.

She was over 100, and she passed away recently. My regards to the family. She’s kind of inspirational. And so, what I had heard from somebody’s speculation was that the family was holding on to the team, at least in part to wait for the step-up in basis. Because when she inherited the team, I don't know what it was worth, but not billions. There were a lot less zero behind that number.

John: Yeah, I think that’s one of the key things. And so, to talk about that step-up in basis so people understand what we're talking about. Let's say I put $10,000 into an investment in Apple or Microsoft. I bought a stock for $10,000. Now it's grown and it's worth half a million dollars. If I were to sell that, I'd pay taxes on all that gain. I'd pay taxes on $490,000. If I gift it to my children, then when they sell it, they pay taxes on $490,000.

Bridget: Right.

John: But if I hold it, and they inherit it, which sounds the same as being gifted but it's not, they can sell, that's that investment. $500,000, zero taxes on it because the basis gets stepped up from $10,000 to the half a million dollars it was worth at the date of my death. So that's one thing. And I love that example about the McCaskey family and doing planning around gazillion dollar sports franchise. I inherited a shotgun when my grandpa died, not a football team. But I'm pretty happy with that too. It seems like, oh, this gigantic thing, but we've got folks, I'm sure you do too, for whom this strategy matters. A client’s dad said, “Hey, I've invested in some stock, and I want you to have it.”

So he gifts it and then two years later dad dies. If the dad had just hung on to it, the son could have sold the whole thing zero taxes. Instead, son's dealing with a big tax bill again. A first world problem. Oh geez, you got a bunch of money. But these are the things that so-called wealthy people take advantage of. It sounds like a good thing. “Geez, I don't need this anymore. Here, daughter, have this.” But really that’s not the case. I'm going to hang on to it until I die. And then you get it, and you save a whole boatload of taxes. That’s one of the strategies that regular people can use.

Bridget: All right, so we got our second rich person. And that is Mackenzie Scott. She happened to be married to the Amazon founder Jeff Bezos. Tell us what she's doing.

John: One of the ways people who have a lot of wealth can avoid taxes is by giving it away in various fashions. We just talked about how giving it to your kids might not make sense. There are some places where it really does make sense. But one of the things is giving to charity and being charitable with it. Now, of course, you don't have access to that money. So when I give it away, it's not mine anymore. However, a lot of us have the inclination to do good and to help out different causes.

And what Mackenzie Scott's doing is rather than just writing checks all over the place and rather than setting up a foundation which is super complicated and has a lot of overhead expenses, albeit some benefits, but do I need to do a foundation? Somebody who’s got hundreds of millions of dollars is probably a good candidate compared to somebody like me. Mackenzie Scott uses the same tool that I use called a Donor-Advised Fund (DAF), which is like a mini foundation for people that aren't super-duper rich.

And Mackenzie Scott funnels hundreds of millions of dollars in charity through her Donor-Advised Fund. And there’re some tax advantages. She can put money into it, this sort of step up and basis thing. She can put some of that Amazon stock that has no basis. She got it for basically free, and now it's worth a gazillion dollars. Put it into the Donor-Advised Fund and get some big tax advantages. But it's one of those things that you use with your clients as well. Donor-Advised Fund sounds pretty boring. Yep. Except for that's what people who are in the know are using to avoid taxes.

Bridget: Yeah. And I gotta say, that is a client favorite. They like the Donor-Advised Fund because they get to be grantors. And once you get the hang of it, it's pretty easy to deal with. So I really like Donor Advised Funds.

John: Yeah.

Bridget: All right, so we have another rich person, Peter Thiel. And you know what he did? This is smart but geez it takes a lot of money. He figured out how to put his stock in…what company did he start?

John: PayPal, I think.

Bridget: Right PayPal. And he gets the stock shares in a Roth IRA. That's where he gets them paid out to. I don't know exactly how he accomplished that, but he puts them in his Roth IRA and then they grow tax free. And unlike regular IRAs where you have required minimum distributions, with Roth IRA, you don't even have required minimum distributions. So you can just leave that in there to grow. Sell it if he wants—tax free. Leave it in there to grow.

If you can figure out how to do that and if you have the foresight, this is a great option. The problem is, if you start a business, who knows if it's even going to take off? By the time it's worth something and you go through these steps, it might be too late. I mean, a lot of us, when we're starting a business, we're just hoping it goes well. We're not trying to figure out how to put stock shares in a Roth. What are your thoughts?

John: Well, and the thing that my mind kind of jumps to is I'll have people periodically say, “Geez, I want to own real estate in my IRA or in my Roth IRA.” That's a common one. Owning your business, it can be done for sure. It's not like it's illegal. However, there are some real, very onerous requirements when you're doing this. So you've got to be really careful and get expert help with this. So it's one of those things that you probably wouldn't take your startup business because there's a lot of red tape and it can be a big problem.

And if I remember right, Peter Thiel was starting to put money into Roth IRAs back when he could put like $2,000 a year in. Chunk, chunk, chunk. And then of course, things took off for him. Can it be your individual company? Absolutely. But golly, there's a lot of red tape and a lot of ways you can trip up. But taking things like your risky stocks, the things that you're taking a flyer on perhaps. And when it's a third-party stock, not someplace that I own or work directly personally or have control over, then most, if not all that red tape goes away.

And you go, “Okay, do I want to have in my CDs in my Roth IRA?” There’s nothing wrong with that in the right situation, but CDs aren't growing very much. I'm gonna put some penny type stock or here's something that a friend of mine works at and I can buy a lot of it for cheap. And it's probably not going anywhere. But if it takes off and it's the next PayPal, I could have a lot of money. I think Thiel started with $2,000 a year and it turned into a $5 billion Roth IRA because it was PayPal or whatever. And then doing some other investment in those things so we can grow to this giant number.

Putting your high-risk things from an investment standpoint can make sense. I think you do the same thing, but we talk about having a gambling account, 5 or 10% of your money. It's fun to research and figure things out. I've got this idea, but how’s this going to go? The real money is invested in a diversified primarily index-based portfolio. But, listen, here are some places where local companies or things that I'm passionate about can fit, like taking those highflyers and putting those in your Roth IRA.

When you do hit a home run, that can be a spot where suddenly you've got some tax-free month, probably not $5 billion, but maybe several hundred thousand dollars of tax-free money. And if you had a grand slam, you get a million dollars. I mean those are the places where it happens. So I'd encourage people to think about asset location. Where am I going to have my high risk things? Roth IRA is a great place for avoiding taxes too.

Bridget: And you mentioned real estate. So let's move on to our next idea, and I don't even have to mention names of people who have done this. I think everybody knows somebody in their locality who’s done this. And that is: invest in real estate. I don't love real estate as an investment. I like the stock market a lot better, because I think it pays better returns. However, the high side is pretty high for real estate. If you get the right real estate, it can really go up. So there’s plenty of wealthy people who end up investing in real estate.

John: It reminds me of our friend Burt Whitehead saying that the real estate's made more millionaires in the United States and also caused more bankruptcies. It works in both directions.

Bridget: Right.

John: But this is one of the reasons why having real estate inside of your IRAs is not an awesome idea. There's a number of reasons why it is, but one of them is that when you buy a piece of real estate that has a building on it, you get to take depreciation on that building. And it's too complicated for us to get into in the time we have left here today, but basically depreciation goes to offset a lot of the income that comes from rents and things like that. And people who have enough money can invest in bigger real estate, and that depreciation really offsets so much of the income. In many cases, there's no tax on any of the income.

And then you can transfer that building into another building and transfer that into another building and potentially even take advantage of that step-up in basis we were talking about earlier. So it's complicated. I'm like you. I've owned real estate. I don't want to own too much more real estate from an investment standpoint. But it can be a great place to shelter taxes and to build wealth if it's the right fit for you. So that's one of the places that is available to regular people.

Bridget: Yeah. And so, I would say there’re a few key factors that you just mentioned. One is while you can depreciate the building. So that means if it costs $100,000, you can depreciate it over 27 and a half years, so that means you can take a chunk of that every year, even though most of the time real estate's going up in value. So even though the value of it is going up, you get to take some of that as an expense every year.

And then it's a complicated tax situation when you sell, but a whole part of that is going to be capital gains and that's at a lower tax rate, so that's a big advantage. And then the other thing you mentioned is even the capital gains you should be able to do, as you mentioned, a 1031 exchange. I know I said that fast because that's the last thing I want to get into a lot of details about. But you can do a like-kind exchange if you want to buy another investment property.

John: Yep, that's great. I think it's a great place to wrap things up here. Use some of the tools we talked about here. From Roth IRA to Donor-Advised Funds giving to charity, holding on to things until you die to pass to heirs, there’s a lot of the tools that wealthy people use to avoid taxes that are available to all of us. And with that, I'm John Scherer, and I've got a fee-only financial planning practice in Middleton, Wisconsin.

Bridget: And I’m Bridget Sullivan Mermel. I’ve got a fee-only financial planning practice in Chicago, Illinois. John and I are both members of the Alliance of Comprehensive Planners. If you live in a different area and you're looking for an advisor in your area other than John and myself, you can check out acplanners.org.

John: And don't forget to hit that subscribe button.

At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation.  We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.