The story about how Warren Buffett pays less in taxes than secretary broke the internet.
No, Warren Buffett does not pay less in overall tax payments than his secretary, but he pays a lower tax rate than his secretary.
This story appeared all over social media and news outlets, and it led toward outcries for reform regarding capital gains and dividend tax treatment.
Here is the original article from CNN if you are interested in reading it.
Effective vs. Marginal Tax Rates
First, we must draw the distinction between marginal tax rates and effective tax rates in order to properly demonstrate this story.
According to Investopedia, a marginal tax rate “is the tax rate incurred on each additional dollar of income.
Under a marginal tax rate, tax payers are most often divided into tax brackets or ranges, which determine the rate applied to the taxable income of the tax filer.
As income increases, what is earned will be taxed at a higher rate than the first dollar earned” while an effective tax rate “is the average tax rate paid by a corporation or an individual.
The effective tax rate for individuals is the average rate at which their earned income, such as wages, and unearned income, such as stock dividends, are taxed”.
The United States has a progressive income tax system as shown below:
This means that anyone making over $38,701 falls into a marginal tax bracket higher than 22%, and this is the case for Warren Buffett’s secretary.
Their effective tax rate, however, will be less than 22% due to deductions and how income taxes are calculated.
Contrarily, according to Investopedia, a “Capital gain is a rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price.
The gain is not realized until the asset is sold.
A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes”.
Short-term capital gains are taxed at your ordinary tax-rate, which is why they are extremely tax inefficient.
Here are the tax rates for long-term capital gains (any investment that has appreciated and was held for more than one year):
Dividends are taxed at these favorable long-term capital gains tax rates. Qualified dividends have three requirements:
- The dividend must have been paid by a U.S. company or a qualifying foreign company
- The dividends are not listed with the IRS as unqualified
- The required dividend holding period has been met.
So, what does this tell us about Warren Buffett’s taxes?
His entire income is essentially derived from qualified dividends and capital gains.
Under the current US tax system, he will never pay more than a 20% tax rate on his income.
There is a net investment income tax that will tack on a few percentage points towards his effective tax rate.
Tax Rates to Watch
The 2020 presidential election will prove to be a pivotal turning point in the future of this story. Bernie Sanders’ surge has a lot of capital gain investors worried.
Sanders is currently the national front-runner, and he is proposing massive wealth taxes on the super rich.
Most of the Democratic candidates support raising the capital gains and dividend tax rate to 40% from 20%.
This would mean that Warren Buffett would no longer pay a lower tax rate than his secretary.
Warren has been a strong proponent that tax rates on capital should be similar to earned income. He gives millions to Democrat causes every fiscal year.
Higher taxes could null and void this popular story of Warren Buffett paying lower taxes than secretary.
“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
Notice very carefully that the amendment says “income“, not wealth! Income is money that an individual or business receives in exchange for providing a good or service or through investing capital.
Income is inherently different than wealth. Many people still confuse income and wealth all the time, even millionaires in this study!
Wealth refers to the net worth of a household. It is calculated as assets – liabilities, or (what you own – what you owe).
Household income is merely realized income to be reported on one’s personal income tax return.
Thus, the Constitution only allows the government to tax realized income.
Warren Buffett has a large net worth, but his realized income (what is taxable) is actually very small in proportion.
Try to create an income stream derived from qualified dividends. Qualified dividends have preferential tax-treatment
The rate will more than likely be lower than your earned income tax rate. Learn how to never pay taxes again!
Hold your winning investments for longer than a year in order to capture long-term capital gains tax treatment.
Long-term capital gains usually have much lower tax rates than short-term capital gains.
This becomes even more important if you are in a high-income tax bracket.
Avoid these five investing mistakes!
Warren Buffett Pays Less In Taxes Than Secretary
This is how Warren Buffet pays less in taxes than secretary! To learn more about taxes, read my latest article to learn how you can limit your tax bill this year.