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Buffett’s Million Dollar Bet

As we near the end of the year, the big issue of the Bush tax cuts [3] remains unresolved. As we inch into December and still have very little idea as to how the tax brackets [4] will look next year, I thought it would be interesting to take a look back at a popular sound bite from Warren Buffet.

One of Warren Buffet’s most famous quotes is that he pays a lower tax rate than his receptionist. He’s said it numerous times, including at a $4,600 a seat fundraiser for then-Senator Hilary Clinton. His exact quote from that night [5] – ““The 400 of us [here] pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies, for that matter. If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”

It wasn’t until today, over three years later, that I learned that Warren Buffett called out his fellow Forbes 400 “members” in an interview with Tom Brokaw [6].

How Is That Possible?

At first glance, it seems preposterous right? How would a billionaire pay a lower tax rate than his receptionist? The answer lies in how our taxes are structured. You have two major types of income – ordinary income and investment income. Ordinary income is the money reported on a W-2, which is what most people get. Investment income refers to capital gains and long term capital gains, on assets owned for over a year, the rate is far lower.

If you earned $1,000,000 in income, you’d be in the highest marginal tax bracket of 35%. Assuming only the $5,700 standard deduction (and no other deductions or credits), you’d pay a composite tax rate of around 32.5% on that $1,000,000 of income. Now imagine if you earned $1,000,000 in long term capital gains – you’d only pay 15% since that’s the long term capital gains rate. You pay twice as much if the earnings comes in the form as ordinary income.

The Forbes 400

The 400th person on the Forbes 400 from 2008 (24 people are tied for 377th) has a net worth of $1.3 billion. Now let’s just take 1% of that, or $13 million, and put it into a basket of dividend stocks that earn around 3%. 3% of $13 million is $390,000 a year in dividend income. Dividend income is taxed at a mere 15%.

Most billionaires probably have more than 1% of their net worth invested in these “safer” types of investments. They also probably don’t draw much of a salary, relative to their investments. So Warren Buffett is not going out on a limb by saying billionaires pay a lower tax rate than their secretaries/administrative assistants.

Arguments as to why this is OK:

Everytime we do a post on taxes I’m eager to hear you’re opinion on it, so let me know what you think!