Last fall, billionaire Warren Buffett ignited a firestorm in the tax world when he revealed that he paid just 17.4% in tax — a lower rate than his own secretary — on his $39.8 million taxable income. The revelation sparked conversation across the country, and even inspired President Obama to propose a “Warren Buffett” rule imposing a special tax on income above $1 million per year.
Last week, Presidential candidate Mitt Romney made similar headlines when he released his taxes. The returns weighed in at 547 pages, and included some items, like “Form 8261: Return By a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” that most tax professionals never encounter in a lifetime. (Trust us when we tell you this stuff is every bit as exciting as it sounds.) Romney’s not quite in Buffett’s financial league — his 2010 taxable income was a “mere” $17.1 million. But Romney’s actual tax rate was a similarly low 17.6%.
We’re not here to take sides on Romney himself, his campaign, or the tax system that makes his 17% rate possible. But Romney’s return illustrates a crucial lesson about your taxes, too — namely, that when it comes to paying less, how you make your money is even more important than how much money you make.
Romney’s income is more than high enough to put him in the top 35% bracket. That 35% applies to “ordinary” income like wages and salaries, business income, and “passive” income from certain investments. But Mitt made “only” $6.3 million in ordinary income. Most of his income derives from other sources, taxed at lower rates:
• Long-Term Capital Gains: Tax on long-term capital gains is capped at 15%, no matter how much gain you report. For 2010, Romney drew over half his income from such gains. This included $7.4 million in “carried interest,” related to his work at Bain Capital, and taxed as long-term capital gain. If that income had been taxed at ordinary rates, he would have paid an extra $1.5 million. If it had been subject to employment tax, like salary, the government would have collected another $214,600.
• Qualified Dividends: Tax on qualified dividends is also capped at 15%, regardless of how much income you report. Romney reported $3.3 million in qualified dividends for 2010. It’s worth pointing out that the only dividends “qualifying” for this rate are those that have already been taxed at corporate rates ranging from 15-35%.
• Tax-Free Municipal Bonds: Muni bonds are a traditional tax shelter for taxpayers in Romney’s “1%” category. But Romney’s home state of Massachusetts imposes a flat 5.3% tax, which makes munis less attractive compared to taxable bonds, for those with stratospheric income. So Romney reported just $557 in muni bond income for 2010.
If Romney winds up carrying the GOP flag in 2012, his taxes will be a campaign issue. But it’s important to remember that, while some are criticizing him as the face of a system gone wrong, no one is actually accusing him of doing anything wrong under the law. In fact, Romney appears to have foregone some legitimate opportunities (like potential home office deductions for his speaking and director’s fee income) to pay even less.
Judge Learned Hand famously wrote that “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury.” (And with a name like Learned Hand, well, you just have to believe him.) We’re here to help you arrange your affairs so that your taxes are as low as possible — and do so in a way to survive scrutiny even if you decide to run for office. And remember, we’re here for your friends, family, and running mates, too!