“Let me tell you about the very rich. They are different from you and me.” Novelist F. Scott Fitzgerald wrote that long ago.

And the rich are different.

But not in the way most people think. Yes, they “have money.” Yes, some even “come from money.” But that doesn’t tell us very much.

Learning how the rich are different

Fortunately, we can get a whiff of how the rich are different at this time every year. This is when I do the paperwork so a CPA can do the Burns household tax return. Now, even though I am mostly retired, I get a small window into the difference between the rich and the rest of us.

If you’re rich, your income comes from your capital. It doesn’t come from your labor.  If your income comes from capital, you can have 10 times the income of the median worker and pay taxes at virtually the same effective tax rate. (See table below.)

My tax preparations tell me, rather bluntly, that most of our income is taxed as regular earned income. Some comes from recent labor. But most of it comes from having labored in the past.

It’s not treated as though it comes from capital. That – capital — is what we call the assets and investments we need if we want to make the transition from working stiff — even affluent working stiff — to “rich.”

You can check this for yourself by reviewing your sources of income.

 Here’s my list.

— Work income. That’s income from writing columns, pure and simple. I pay both federal and employment taxes on that.

— Social Security benefits. This income reflects a lifetime of earning and paying employment taxes. Our dear friends in Congress agreed to make that income taxable over 30 years ago. The only way to escape the tax is to have very little income from other sources.

— Corporate pension. This is deferred compensation. So it’s labor income. It’s money my employer put aside for when I no longer worked. Sadly, fewer and fewer people have this benefit.

— Retirement account withdrawals. Again, this comes from labor income that was deferred in 401(k) and IRA plans. Taxes on that income were deferred, too.

Significantly, even though much of the money from pensions and retirement accounts is really from investment returns, it’s treated like regular income and taxed accordingly.

What does “accordingly” mean?

Labor is taxed more than capital

There’s the rub. It means that wherever you are on the labor income tax scale, you pay taxes at higher rates than the people whose income comes from capital, not labor.

So what counts as income from capital? Think dividends, capital gains and rents. It has special tax treatment that can make much of it disappear – just for tax purposes. What is visible and taxable pays at the lower, preferential rate that applies to capital gains and qualified dividends.

That income, if you have enough of it, is what makes you rich.  You can pay your bills without working. Have a ton of it, and you can get your passport to what wealth writer Robert Frank called “Richistan,” a place he saw as  “its own virtual country.”

Peeking into Richistan

Richistan is a different country from the one in which most of us live. I get a peek into it every year when I examine our toehold in the outer regions of Richistan. That’s when I look at our income from real estate, stock index funds and a very small collection of individual stocks.

Some of this income isn’t taxable due to depreciation — in spite of the fact that the real estate is becoming more valuable every year. The dividends are taxed at 15 percent because they are “qualified.”  And the realized capital gains? Yeah, they’re taxed at 15 percent too, unless capital gain and dividend income exceeds $434,550.

To get to that rate, you need to be really rich.

It is, as some would say, “a whole ‘nuther country.”

If your income comes from capital only, your tax rate up to $434,550 will be slightly less than the 15.51 percent effective tax rate paid by median-income workers. That’s people with incomes of $40,100. (See table below)

If your capital income exceeds $435,550, you’ll pay at a 20 percent rate. That’s a bit less than the 21.12 percent effective rate paid by those earning $80,000, workers entering the top 20 percent of earners.

The difference is why Warren Buffett can say that his secretary pays taxes at a higher rate than he does. While her income comes from labor and pays federal income and employment taxes, the vast majority of his income isn’t visible or taxable. And his income that is taxable pays at capital gains or qualified dividend rates.

The rate difference is why it’s so difficult to leave working America and cross the border to Richistan.

The border has a wall. It’s a big wall made of tax rate preferences.

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Related columns:

Scott Burns, “When the rich have it all,” 8/4/2019  https://scottburns.com/when-the-rich-have-it-all/

Scott Burns, “The other road to serfdom,” 10/12/2019  https://scottburns.com/the-other-road-to-serfdom/

Scott Burns, “Eat the rich and take their money (continued),” 9/1/2019  https://scottburns.com/eat-the-rich-and-take-their-money-continued/

Scott Burns, “Is it time to eat the rich?,” 8/17/2019  https://scottburns.com/is-it-time-to-eat-the-rich/

Scott Burns, “Is it time to eat the rich?,” 11/14/2010  https://scottburns.com/is-it-time-to-eat-the-rich/

Sources and References:

Tax calculations from https://smartasset.com/taxes/tax-return-calculator

Income percentile rank calculations from  https://dqydj.com/average-median-top-individual-income-percentiles/

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: William Sun/ Pexels.com

(c) Scott Burns, 2020