Why Mitt Romney & Other Wealthy Investors Pay Less Taxes

Mitt Romney is very rich.

That Romney, the former governor of Massachusetts, is wealthy comes as no surprise. But the Republican presidential candidate offered up some details last week, with the release of two years’ worth of tax returns. 

The Romneys -- like many taxpayers -- received a tax refund for their 2010 filing. But at $1.6 million, their refund was slightly higher than the IRS-reported average of $3,003.

In 2010, Romney and his wife totaled $21.6 million in income and paid slightly more than $3 million in federal income taxes. That's good for an effective tax rate of 13.9 percent, according to the documents he released. Last year, according to estimates Romney released, the pair took in $20.9 million, on which they will pay $3.2 million -- 15.4 percent of their income. 

(The Obamas, by way of comparison, had $1.7 million in income in 2010 and paid an effective tax rate of 26.3 percent.)

So how does a man worth hundreds of millions end up with a tax rate similar to that paid by a household earning $50,000 per year?

The answer lies not in any shady accounting or financial trickery, but in the federal income tax code, explained Joseph Newpol, a professor of law, taxation and financial planning at Bentley University in Waltham, Mass.

“Essentially, the policy is this: if you have income from capital, we’re going to tax it at a preferential rate,” Newpol said.

Most workers are familiar with the progressive income tax: Money earned in wages or salary is taxed at a higher rate the more you earn. For 2011, a married couple earning a total of $50,000 – after deductions – is subject to a maximum tax rate of 15 percent; those earning more than $379,150 will pay 35 percent on some of their income. 

But capital gains – the profit made from selling an asset, such as real estate or stocks – are taxed differently. Though there are some exceptions, this money is generally assessed at a rate of 15 percent.

For tax purposes, other income also falls under the capital gains rate, including carried interest, which is when an individual is paid a portion of the profits generated by a fund or partnership. 

In Romney’s case, $12.6 million of his 2010 income was classified as capital gains, according to his tax filings. Had that money been paid as salary or wages, most of it would have been taxed at 35 percent; instead, it was assessed at less than half that rate.

The rationale behind the lower capital gains rate, Newpol said, is that “we want to encourage people to invest in stocks, bonds and things like that because that’s good for the economy, it creates jobs.”

Though Newpol is skeptical that lower capital gains taxes have this desired effect, he said that the tax code has long incorporated preferential rates for capital gains. The current rate came about in 2003, when Pres. George W. Bush implemented a package of tax cuts that included a provision to lower the capital gains tax from 20 percent. 

Romney’s wealth also made it easier for him to take certain deductions, such as the one for charitable donations. In 2010, the presidential hopeful and his wife gave away $3 million, thus reducing their taxable income by that sum. They also claimed a deduction of nearly $900,000 for state and local taxes they paid.