According to U.S. News & World Report, typical high-net-worth individuals hold between $1million and $5 million in liquid assets. If you’re a high-net-worth individual, it’s essential to be informed about the tax-planning strategies available to you. Below is a list of several tax strategies designed to optimize wealth preservation and tax efficiency.
Max Out Your Retirement Savings Options
One of the first strategies is to maximize your retirement savings. This can be done using an IRA, a 401(k) plan, or another retirement savings plan. Each of these plans may have traditional (pre-tax) or Roth (after-tax) options. It is important to consider your current tax bracket and anticipated future tax bracket when determining the amount to contribute to either a traditional retirement or Roth account.
Minimize the Use of Active-Management Brokerage Accounts
The more you trade, the more you’ll be taxed. Realized gains in a brokerage account become taxable whenever a trade takes place. Actively managed brokerage accounts tend to trade frequently. Active management may result in you paying higher taxes than you should, and it rarely leads to a better investment performance.
Tax-Loss Harvesting
This strategy involves selling off securities held in a brokerage account that have gone down in value and replacing them with other similar, but not identical securities. This can be especially helpful when the markets drop significantly (as happened in 2020). It’s important, however, to be aware of the IRS’s “wash sale” rule.
Use Your Roth IRA Conversion Opportunities While You Have Them
Certain situations may arise where converting your traditional retirement savings (pre-tax) to a Roth IRA (after-tax) can be done with lower-than-anticipated taxes owed. If you time your conversions well, you can remove substantial portions of your wealth from the Required Minimum Distribution (RMD) calculation. However, there are many ways to go about this and many variables to consider.
Be Smart with Your Withdrawal Strategy
Some retirees think that they shouldn’t touch their retirement savings plans until they are required to do so by the IRS. Typically, this thought is based on the idea of paying as little in taxes for as long as possible. However, this can potentially result in a larger cumulative tax liability in retirement. Generally, a retiree will want to create a taxable income stream that is as smooth as possible and avoid creating peaks and valleys.
Charitable Giving Opportunities
Charitable giving is usually a part of tax-planning strategies for high-net-worth individuals. Planning for charitable giving can take the form of donating appreciated property, since you can bypass the capital gains tax on the appreciation while claiming a tax deduction for the value of the appreciated property donated.
Many high-net-worth retirees who are over 70.5 years old can make a direct transfer of funds from their retirement savings plan to a qualified charity. This is called a Qualified Charitable Distribution (QCD). Once a retiree begins RMDs (the age when you are required to do this depends upon the year you were born), any amount transferred as a QCD counts toward your RMD for that tax year – up to $105,000 – and keeps the amount donated from being included as taxable income on your tax return.
Recently, another common planning tool is a donor-advised fund. With a donor-advised fund, you can contribute a substantial lump sum, which is fully deductible in the same fiscal year. This is most often used when someone has a significant increase in income (i.e. the sale of a business) and wants to offset some of the capital gains with a charitable contribution but hasn’t yet identified specific charities. Thus, a donor-advised fund can help lower your taxable income. As a bonus, you maintain control of the donor-advised fund — allowing you to determine which charities will receive the donated funds and the timing of those distributions.
Minimize the Taxes on Pre-Tax Retirement Savings Accounts
Whenever a high-net-worth individual passes away and leaves pre-tax retirement savings accounts to non-spousal heirs, there is a potential windfall for the IRS. This is the result of recent changes in the law that require these heirs to withdraw all of the funds within a short period of time — typically, no longer than ten years. This short time frame can result in the income being bunched together into a few years and taxed at a higher tax bracket. Your goals and values, and the financial situation of your heirs, will determine your planning around this potential issue.
Protect Your Wealth by Consulting with a Qualified Tax and Wealth Management Advisor
Whether your wealth came through your sweat equity or from inheritance, you will gain peace of mind by ensuring that it lasts to take care of you and your family. Deliberate tax planning before the filing season, and throughout the year, can help you keep more of what you earn and minimize what you pay in taxes. Every individual and family situation is unique. This list doesn’t cover all the potential tax strategies available. Consult with a tax and wealth management advisor.
Terry L. Roe, MAcc, CPA/PFS, CFP® is a financial advisor with Onyx Financial Advisors, LLC, an independent fee-only registered investment advisory firm located in Idaho Falls, Idaho. He can be reached at (208)522-6400.