Question

Warren Buffett stated that he paid an effect tax rate that was lower than that of his secretary. This assertion is probably true. Why?

Answer 1

Buffett, one of the richest people in the world, is probably paying a lower tax rate on his income than his secretary.

How is this possible? Simple. Buffet takes advantage of capital gains taxes and lengthy stock holding periods.

How capital gains taxes give Buffett an edge
Buffett has often emphasized the importance of long-term investing in his shareholder letters and annual meetings. Putting into practice what he preaches has made a big difference when it comes to him paying a far lower tax rate than many Americans.

Buffett himself only takes home a $100,000 salary each year as the CEO of Berkshire Hathaway, although there are other areas where the Oracle of Omaha is compensated. The remainder of Buffett's taxation comes from capital gains taxes.

Capital gains tax rates are pretty cut-and-dried. If you own a stock or bond for one year or less, it's considered a short-term investment. As such, the individual claiming the gain will pay an ordinary income tax rate commensurate with their peak marginal tax rate. For the super-rich today that could work out to a 39.6% tax.

The magic happens when you hold onto an investment for a year and a day or longer. Selling a stock beyond this point and claiming a capital gain allows an investor to substantially reduce their tax liability on the gain. Taxpayers in today's 10% or 15% ordinary income tax bracket would owe zero, zilch, nada, on their long-term capital gains based on the 2016 federal tax tables. Taxpayers in the 25%, 28%, 33%, or 35% ordinary tax brackets owe just 15% on their long-term capital gains. Finally, the super-rich, which would encompass anyone bringing in more than $415,050 as an individual or $466,950 as married filers in 2016, would owe just 20%.

Imagine this for a moment. Let's assume Buffett were to sell stock and claim $1 billion in long-term capital gains. His tax on this amount? Based on 2016's tax schedule, he would be responsible for paying a 20% tax (plus a potential 3.8% net investment income surtax which is tied to the Affordable Care Act). By contrast, a worker with no investment income who earns $37,651 in 2016 finds themselves stuck in a peak ordinary income tax bracket of 25%. Understandably effective tax rates for both individuals would be lower than their peak marginal taxes rates, but this difference clearly shows how long-term capital gains significantly favor the rich. It's a tool that Buffett has used to keep a good chunk of his money.