The easiest way to supercharge your investments is to keep Uncle Sam’s hands off your profits. There are many approaches to getting taxes on investment profits down to 0 or very close to it. Keeping 100 cents on the dollar versus 80 or 60 is a huge difference. Savvy investors make sure to be as tax-efficient as possible.
So, let’s get savvy! To keep this article to a manageable length, I will just touch on each strategy or tool. Ask your tax advisor if they are appropriate for you. In future articles, we will BH elaborate on each one specifically, so “stay tuned.”
Roth IRA/401(k)
Roth retirement accounts are funded with after-tax money, meaning you don’t get a tax deduction upfront. However, investments grow tax-free, and withdrawals in retirement are also tax-free, provided certain conditions are met. Using backdoor Roths and 401K accounts, you can accumulate a relatively large tax-free portfolio quickly.
HSA (Health Savings Account)
An HSA allows you to save money pre-tax for medical expenses. Contributions reduce your taxable income, investment growth is tax-free, as are withdrawals for qualified health expenses, a true tax bargain. HSAs are only available to those with high-deductible health plans, however, and the amount you can put in annually is relatively low.
529 Education Savings Plans
529 plans let you save and invest tax-free for qualified education expenses. Money goes in after-tax, but earnings grow tax-free. Since up to 10K per student may be removed annually for K -12 tuition, 529s enable tremendous tax-free investment flexibility for those with many children and grandchildren. For example, millions can be accumulated to cover all grandchildren’s future yeshiva tuition.
Cash Value Life Insurance
Some life insurance policies have a cash value component that grows tax-deferred. Withdrawals up to the amount of premiums paid are tax-free, and loans taken against the policy are not taxable income. Death benefits are also not taxed, making life insurance a unique vehicle for tax-free wealth expansion and inheritance tools.
Real Estate Professional Status
Real estate is at the pinnacle of investment tax efficiency. Several upcoming strategies and tools are uniquely suited for real estate investors, and the combined effect of these tools in one asset can sometimes make real estate financially magical.
This magic is especially pronounced for “real estate professionals” as defined by the tax code, who can often pay zero tax even on their regular income! Gaining real estate professional status can be a true financial game changer. The rules are particularly complex, so proceed cautiously.
Depreciation “Losses”
Rental property owners can deduct the costs of buying and improving a property over its useful life, i.e., depreciation, reducing taxable income. Using cost segregation and bonus depreciation, significant passive losses can easily be created above the properties’ rental income, which can be used to offset other passive income or carried forward.
1031 Exchange
This strategy allows you to defer paying capital gains taxes when you sell a property or other tangible asset if you reinvest the proceeds into another “like-kind” property. It’s a way to keep your investment growing tax-deferred. 1031 exchanges can enable investors to grow ever-expanding portfolios tax-free.
Using Debt or Refinancing
Borrowing against your investment property or home equity can provide funds without selling assets, avoiding capital gains taxes. Ideally, these funds will be used to buy more property, which can then be refinanced tax-free to buy even more property!
Step-Up in Basis
Capital gains accrued and deferred during a lifetime of investing are wiped away after 120! When you inherit property and then sell it, capital gains taxes are based only on gains after the original owner’s death, reducing taxes significantly. Basis step-up, as its called, applies to stocks and business assets, too, but its benefit really shines in inherited real estate.
Why? Debt-free refinancing, depreciation, and 1031 exchanges defer taxes owed. But then, what? The accumulated tax bill can be gargantuan. Not if it culminates in a step-up in basis. Fortunes can be enjoyed across generations tax-free. ( Estate taxes need to be dealt with separately, however. A different sugya.)
Personal Home Gains Exemption
When you sell your primary residence, $500,000 of the gain is exempt from capital gains taxes for married couples filing jointly, provided you lived there for at least two of the five years before selling. This exemption can be used multiple times and significantly affects many everyday Americans whose primary home is their largest financial asset.
0 Capital Gains Bracket
Those with income below a certain level qualify for a 0% capital gains tax rate on long-term investments. This means you could sell investments held for more than a year without paying federal capital gains taxes. Parents in higher tax brackets may use this loophole effectively by gifting their adult children appreciated investment shares instead of cash.
Charity and Donor-Advised Funds
Contributing to a DAF allows you to donate cash, stocks, or other assets and receive an immediate tax deduction. Over time, you can recommend grants from the fund to charities of your choice. But the money can also remain invested and grow tax-free to maximize future contributions.
Gifting appreciated assets like stocks directly to charity avoids accrued capital gains taxes. This offers investors a double tax whammy, as they get a full tax deduction and avoid capital gains on the growth.
UTMA Custodial Accounts
UTMAs allow you to invest assets for minors until they reach adulthood. A minor child’s lower tax bracket enables the recognition of thousands of dollars of gains annually tax-free. Keep in mind that UTMAs are penalized during FAFSA-driven college grants.
Small Stock Exemption
With proper planning, business owners who sell parts or all of their equity shares can save a fortune in taxes. Small business stock (QSBS) held for more than five years may qualify for a 100% exemption from federal capital gains taxes, up to $10 million or 10 times the adjusted basis of the stock. And by bringing in family members this protection can be expand significantly too! Talk about the rich getting richer!
Opportunity Zone Investments
Investing in designated economically distressed areas can offer tax benefits, including deferral of capital gains taxes and potential exclusion of future gains from taxes if the investment is held for at least ten years. Sophisticated QOZ investors who can navigate the quirks can benefit from these modern tax-free structures.
Expanding Your Tax Toolbox
Depending on your financial situation and goals, some approaches may be more suitable than others. Each one has its own nuance and pitfalls. It’s always recommended to consult with a tax professional or financial advisor to make the most informed decisions. But now you are at least familiar with some of the most powerful taxtools in the savvy investor’s toolbox.
Want to dig deeper?
Try these related articles
Stop the Real Estate Taxman with 1031 Exchanges
529 Savings Plans: Getting Creative with a Tax-Free Investment Structure