Strategic tax planning offers many benefits, particularly for high net wealth individuals. Employing the right strategies allows you to reduce your state and federal tax liabilities effectively. In many cases, these strategies can benefit communities and charitable organizations. Let’s take a closer look at how to reduce taxable income using effective legal strategies.
How to Reduce Taxable Income: 6 Tax Strategies for High Net Worth Individuals
1. Donor-Advised Funds
A donor-advised fund (DAF) is an investment account created to support charitable organizations. With a DAF, you can make a donation, receive an immediate tax deduction and then recommend grants to be given from the fund over time.
Donating to a DAF may make you eligible for an itemized tax deduction. The deduction’s amount will depend on a few factors, including:
- The type of asset
- How long you’ve owned the asset
The nature and structure of a DAF allow you to plan your gifting for when it makes the most sense for you. It can be an effective way to reduce your tax burden after a windfall and then recommend grants in the future. Effectively, you are pre-funding your gift-giving after a high-income event to reduce your immediate tax burden.
Along with cash contributions, non-cash assets may be donated, such as:
- Real estate
- IPO stock
- Publicly traded securities
- Fine art and collectibles
Once assets have been gifted to a DAF, they are owned by the sponsor organization and cannot be recouped or regained. DAFs do not have annual distribution requirements.
If you have charities that you would like to support, a DAF is a great way to reduce your tax burden while supporting causes you are passionate about.
2. 1031 Exchanges
High-income individuals who own real estate may use a 1031 exchange to defer capital gains taxes when selling an investment property and reinvesting in another similar property.
Simply put, you’re exchanging one investment property for another. Of course, there are rules and limitations here, but generally, a 1031 Exchange allows you to continue growing your investment tax-deferred until you sell the property for cash. When you finally sell, if all goes as planned, you’ll pay just one long-term capital gains rate.
In order to qualify for a 1031 Exchange, the properties must be like-kind, but the rules for this are relatively liberal. For example, you may be able to exchange an apartment building for a strip mall.
That being said, a1031 Exchanges have many moving parts, and there are restrictions. For example, if you have a vacation home that you occasionally rent out, you can’t sell this property and use 1031 to defer the capital gains tax and buy a new vacation home. The property must be either an investment or a business.
However, if you are investing in real estate and plan to continue with your investments, a 1031 Exchange can be an effective strategy for deferring capital gains taxes. It’s crucial to work with a qualified accountant to guide you through the process and a 1031 exchange if you plan to undertake one.
3. Qualified Charitable Distributions (QCD)
A qualified charitable distribution, or QCD, allows IRA holders to reduce their required minimum distributions if they make donations to charities.
Because the money is being donated to charity, the QCD is not counted as taxable income. For IRA owners who do not need their required minimum distributions, a QCD can be a way to reduce taxable income while supporting a cause or charity you are passionate about.
Here are a few things to know:
- A QCD must be sent directly to the charity
- Donations are capped at $100,000
- The IRA owner or beneficiary must be at least 70-1/2 years old
- The charity or organization must be a 501(c)3 organization
4. Income Splitting and Trusts
In areas with bracketed tax regulations, income splitting, and trusts can be effective tax reduction strategies that families can use to reduce their taxes. The aim of these strategies is to reduce the household’s gross tax level at the cost of select family members paying higher taxes.
Here’s an example:
- Bob earns more than his son Joe.
- Bob hires Joe for a job and deducts the cost of labor as a business expense.
- The family’s income is the same, but your overall tax burden is reduced.
Another option with income splitting is to transfer tax credits from a lower-earning family member to a higher-earning family member. For example, children may be able to transfer tuition credits to parents who are funding their college education.
There are several income-splitting strategies that families can use to reduce their tax burden. Trusts can also help reduce state taxes on investment earnings. If you receive significant investment income and live in a high-income state, these strategies can work well to reduce your tax liability.
5. Invest in Qualified Opportunity Zones
A Qualified Opportunity Fund (QOF) allows investors and businesses to temporarily defer capital gains by investing in low-income communities for revitalization. Taxes are deferred on the invested gains until the QOF investment is sold or exchanged.
The longer you keep your investment in the QOF, the greater the tax benefits.
- Holding the investment for five years permanently reduces the gains by 10%
- Holding the investment for seven years permanently reduces the gains by 15%
- Holding it for 10 years will make the gains 100% tax-free
6. Hire Your Kids If You’re a Business Owner
If you own a business, one way to reduce your tax liability is to hire your children (if they are of legal working age). Business owners aren’t required to pay Medicare and Social Security taxes on their child’s earnings as long as they are under 18 years of age and their earnings are taxed at the appropriate tax rate.
Parents considering this strategy should ensure that they are paying their children a fair, market value wage.
Tax planning offers many benefits to individuals, particularly high-income earners. However, these strategies can be complex and require the help of a knowledgeable CPA.
Hire a pro to help you be proactive, plan throughout the year and reach your goals. LLP CPAs can help. Schedule a call today!