The 3 Buckets of Tax Reduction

 

While there are many different strategies and tactics you could deploy, it helps to realize that each one broadly fits into at least one of three buckets: reducing your taxable income, reducing (or eliminating) your capital gains, and planning for (and mitigating) estate taxes.

 

Our examples below are for illustrative purposes only; they are not tax advice. As you hone your own strategy, we recommend you work closely with your tax advisor, wealth advisor and lawyer. They can provide advice tailored to your unique needs. 

Reducing Your Taxable Income

When people casually talk about reducing their taxes, they are most often referring to this. If you’re like most HNWIs, your income is taxed in a high—or the highest—tax bracket, so anything to reduce your overall taxable income (a deduction) or to remove a portion of these taxes dollar-for-dollar (a tax credit) is welcome. 

 

Some Common Examples: 401(k) contributions, Individual Retirement Account (IRA) contributions, Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), Clean Energy Tax Credit, Commuter Benefits, Dependent Care FSAs, Child Tax Credit

 

A Few HNWI Possibilities: Donor Advised Funds (DAF), Qualified Charitable Distributions (QCD), Qualified Business Income (QBI)

 

One Last Takeaway: A high income is likely a (if not the) key driver of your current lifestyle and your ability to achieve your personal goals. However, our advisors occasionally see clients so set on getting their taxable income as low as possible that they don’t have enough cashflow for their lifestyle—don’t hamper yourself just to reduce your taxes! The key here is balance: Reduce your taxable income to the lowest level possible that still allows you to pursue the life you want.

Reducing (or Eliminating) Your Capital Gains

Capital gains taxes are only levied on realized gains—in other words, when an investor sells an asset. Long-term capital gains (assets held over a year) have tax rates lower than the corresponding income tax rate, while short-term capital gains (those held less than a year) are taxed as ordinary income.

 

Many of the more common strategies involve placing funds into specific-purpose investment accounts like a 529 College Savings account or a Roth IRA, which are then allowed to grow tax-free; once in these accounts, trades can be made and capital gains realized without taxation. While there’s no immediate tax deduction for doing this, the long-term benefits can be powerful, especially because down the line you access them completely tax-free, provided you make conforming withdrawals.

 

For HNWIs, there’s also an opportunity to reduce capital gains in their standard brokerage account by borrowing on the value of the account, via Securities Based Lending (SBL), rather than selling securities. It allows for cashflow flexibility at an interest rate typically lower than their corresponding capital gains tax rate.

 

Lastly, home sales that turn a profit are considered capital gains. For most people, if they sell their primary residence to purchase a new one, the gains are exempt up to $500,000 for married couples filing jointly (as of tax year 2024). Even if they rent it out for a year or two first, they likely still qualify for this exemption.

 

For high-net-worth individuals, who have multiple properties, or experienced substantial gains in home value, they may not qualify. In these scenarios, there may be other options to avoid realizing capital gains on the sale of real estate; your tax advisor and lawyer can help you with your specific situation.   

 

Some Common Examples: 529 College Savings Account, Roth IRA, Roth 401(k), Holding stocks for longer than one year to avoid short-term capital gains, Selling primary residence

 

A Few HNWI Possibilities: Tax Loss Harvesting, Gifting Appreciated Securities, 1031 Exchange, Renting out properties long-term, 83(b) Election, Securities Based Lending (SBL)

 

One Last Takeaway: This tax strategy is all about delayed gratification. Especially for individuals with high net worth, it can be beneficial to avoid cashing out on investments—and instead think of ways to continue investing further while maintaining access to cashflow.

Planning for (and Mitigating) Estate Taxes

Two techniques are key to protecting your legacy: wealth transfer planning and estate planning. Wealth transfer planning is about efficiently transferring wealth to heirs or charities during your lifetime. Estate planning is about arranging your estate in a way that comports with your wishes—and ideally minimizes your heirs’ inheritance tax.

 

These two techniques should work in concert. For example, with wealth transfer planning, gifting funds during your lifetime will have multiple effects: Your heirs will see the funds sooner, you’ll get to enjoy seeing your legacy in action and, assuming your gifts are within the federal limits, you’ll transfer the funds tax-free. 

 

In many ways, this is where trusts come in. They can span both worlds—allowing you to transfer assets out of your estate now, while also safeguarding the assets for future generations. While common trusts, like Revocable Trusts, are relatively easy to understand, they are just the tip of the iceberg; it may feel like there are as many trusts as there are situations.

 

This is why a strong team on your side matters. Your legal team should be attuned to your legacy goals and your wealth management team should be experienced. In fact, taking time choosing and vetting the people who set up and manage your trusts is one of the biggest indicators of an effectively executed legacy down the line.

 

Some Common Examples: Annual Gift Tax Exclusion, Revocable Trusts, Special Needs Trusts, Tuition Payments for Children and Grandchildren

 

A Few HNWI Possibilities: Lifetime Gift Tax Exclusion, Family Limited Partnership, Charitable Lead Trusts, Charitable Remainder Trusts, Qualified Personal Residence Trust, Intentionally Defective Grantor Trust, Grantor Retained Annuity Trust, Spousal Lifetime Access Trusts

 

One Last Takeaway: It’s your legacy to leave. Communication about your wishes is crucial: everyone on your financial and legal team should understand what you want and how you want to achieve it. We recommend sitting down and talking through a coordinated strategy with your entire team at least once a year, so that everyone is always up to date.

 

Your Strategy Will Be as Unique as You

While there are 3 buckets of tax reduction, it’s important to realize that many tools may affect your taxes in multiple ways. For example, a traditional 401(k) reduces your taxable income in the year you contribute to it—this is what it’s known for. But, it also allows for those funds to grow (and be traded) free of capital gains tax. The kicker is, once you withdraw the funds in retirement, they’re treated as income.

 

Many other tools, such as starting an LLC or a Donor Advised Fund, will have tax impacts in many directions. Understanding each is crucial: You want to know how all the puzzle pieces fit, so you can be confident you’ll complete your picture. This is where the guidance of experienced professionals comes in. You’ll be able to rely on a team that can help you develop a tax planning strategy as unique as you.