#TBT: How to Make Your Portfolio Tax Efficient
Occasionally, people tell me that they worry about investing because of all the taxes that they may accumulate over time. This is really only a major concern if you happen to be a high net worth individual or a small business owner. However, with the right planning process, these alleged taxes can be mitigated from ordinary, passive, and portfolio income, the purchase/sale of assets (real estate), and retirement/estate planning.
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Tax Planning and Investing Go Hand-in-Hand
First let’s talk about tax mitigation strategies. Tax mitigation is simply the idea of developing investment strategies that reduce your taxes as well as potentially grow your wealth. The choices you make when assets are in motion have tax consequences, and how you manage those consequences can either cost or save you in taxes.
To better understand, let’s look at possible sources of income. There are four categories of income: earned income, investment income (which includes passive income and portfolio income), tax-deferred income, and my favorite—tax-free income. Each category offers different strategies and vehicles to reduce or defer taxes.
What is 'Earned Income'?
Earned income is compensation from employment or the actual involvement in a business. This is the most highly taxed form of income and is the most limited in terms of deductions. With earned income, deductions are generally available after the income is received. For example, if you’re contributing to a pre-tax retirement account that is based on your income, you won’t know how much you can contribute until you have received your income.
What are 'Portfolio and Passive Income'?
Portfolio income is derived from investments and includes capital gains, interest, dividends and royalties. Investments held longer than 12 months have preferred tax rates. Losses can offset gains. Passive income is derived from activities in which you do not actively participate, such as real estate or limited partnerships. Losses have the ability to offset passive income.
With portfolio and passive income, taxes are generally mitigated at the time of purchase or sale. For example, you might consider purchasing one of two investments. The investments are alike in all characteristics except one of the investments has an additional offset to income—depreciation. The investment with depreciation is the more tax-efficient choice, and it is a choice made at the time of purchase.
One strategy involves the use of investments that are passive income generators (PIGs). To take advantage of this strategy the client must have additional investable assets, which are used to acquire the PIG. Assets are available with annual returns in the 8% range that provide 85% to 100% passive income. Income generated through the use of this strategy is effectively tax-free until the passive activity losses (PALs) are extinguished. As a result of the recent economic upheaval, some clients have excess passive activity losses. In some cases, the extent of the PAL is such that they cannot be easily extinguished without external intervention.
What is the 'Purchase and Sale of Assets Including Real Estate'?
With the purchase and sale of assets, the potential to mitigate taxes can occur at both the time of purchase and the sale. The structure of the acquisition is important. For example, in the world of real estate a very common axiom is “You make your money when you buy.” On the other hand, you minimize your taxes when you sell. In the case of real estate, one can possibly defer all taxable gains to a more opportune time through the use of an IRS 1031 like-kind exchange. Other asset sales require different strategies.
Tax-deferred income is derived from retirement accounts. Tax-deferred income can be converted to tax-free income through the use of a Roth account. Other strategies exist for adding to the tax-free income category, including insurance. Achieving tax-free income is the goal.
Each type of income can have tax impacts mitigated by using strategies available in the tax code and by using assets that achieve specific strategic goals.
With tax-deferred income, the account grows tax-deferred. Since withdrawals are taxed at ordinary income rates, one should consider conversion to a Roth as early as possible to limit taxation due to account growth. After all, where do you want to be taxed, on the seed or on the crop?
Tax-deferred income strategies involve structuring a portfolio for tax-efficient retirement plan maximization. Other strategies occur when clients have additional discretionary income that could be more tax-efficiently deployed in a tax-free account.
(This article was originally posted on GradMoney on July 19,2017)