7 Ways to Lower Your Family's Investment Tax Burden

Basic Strategies for Keeping More of Your Money in Your Pocket

Here are some basic ideas that might help you discover ways to lower your investment tax bill.
Here are some basic ideas that might help you discover ways to lower your investment tax bill. krisanapong detraphiphat/Getty Images

You probably already know what truly counts as an investor is the after-tax, risk-adjusted real increase in purchasing power you enjoy from your money.  Minimizing your tax bill is an important part of that equation.  Tax strategies are an expansive topic, so let's focus on seven things you might want to research to help lower the amount of cash you have to send to the IRS every year, keeping more wealth working for you and your family.

1. Take Maximum Advantage of Any and All Legitimate Tax Shelters

Opportunities to shield money from taxes, allowing either tax-free or tax-deferred compounding of capital gains, dividends, interest, and rents have hardly been as abundantly available in the United States as they are today.  From individual accounts such as the Roth IRA, which is the closest thing to a perfect investment tax shelter the average investor is ever going to enjoy, to the now ubiquitous 401(k) plan, which often lets you enjoy free matching contributions from an employer, there is no excuse not to enable your money to grow beyond the reach of the Federal, state, and local government.  Do everything you responsibly can to take advantage of the annual contribution limits.

2. Judiciously Employ Asset Placement Tax Strategies

The exact same asset in a portfolio can generate substantially different after-tax returns based on where it is held.

 For example, a high-income family would hardly ever have occasion to purchase fully taxable corporate bonds in a brokerage account.  Under virtually no condition should a person acquire tax-free municipal bonds within a tax shelter.  Taking advantage, and remaining aware, of the situation is a tax strategy called asset placement.

 Honor it at all times.

3. Avoid Triggering Short-Term Capital Gains If You Are In a High Tax Bracket

Due to the way the United States tax code is written, something magically happens when an investment that is held for more than 12 months is sold at a profit.  The IRS classifies it as a "long-term" gain, subject to tax rates that are substantially lower - some cases, nearly half - of the marginal rates that would have otherwise applied.  The implications of the math is difficult to over-emphasize: It is entirely possible that you can make a lot more after-tax money by sitting tight on appreciated assets until this magic line has been passed than you could had you dumped it quickly, even if you end up selling at a lower price.  Short of some fairly specialized circumstances, if a majority, or even significant, portion of the profits generated by your investment portfolio are classified as short-term, and you are even modestly successful, you're probably doing something dumb.

4. Build Deferred Tax Liabilities That Act as an Interest-Free Government Loan

A tax minimization strategy employed by Warren Buffett, one major advantage of long-term ownership for those investing in individual securities such as stocks is the deferred tax liability that builds up as an asset appreciates over the decades.

 You can exploit this situation by effectively using money borrowed at no-cost from the government to juice your returns above and beyond what would be capable if you were day-trading.

5. Convert Those Deferred Tax Liabilities Into Tax-Free Gifts to Your Heirs Using the Stepped Up Cost Basis Loophole Upon Your Death

One of the most fantastic, amazing, incredible (yes, it's really that wonderful) benefits long-term investors can enjoy is something known as the stepped up basis loophole.  To demonstrate its power, imagine that 30 years ago, you invested $100,000 in a boring, but highly profitable, blue chip stock like Colgate-Palmolive.  You decided not to reinvest your dividends.  Over the years, you were sent roughly $887,557 in cash dividends, which you used to pay bills, donate to charity, travel, put food on the table, buy a new car, and any of number of things.

 You also find yourself sitting on shares with a market value of $3,930,052, representing an unrealized gain of $3,830,052.

If you sell your stock, you're probably going to owe somewhere around $912,000 in Federal taxes, including the Affordable Care Act special tax.  You might owe state and local taxes ranging from $0 to almost $380,000 depending upon where you live.  Under a near-worst-case scenario you could be looking at giving up $1,292,000 in wealth that otherwise would have been gifted to your children, grandchildren, nieces, nephews, and other heirs but now is destined for the hands of politicians.  The stepped up basis loophole gets around this.  By leaving your appreciated stock directly your beneficiaries, provided you are still under the estate tax limits, they get to pretend like they paid the market price for the stock (or, if they opt for the later re-measurement date, the market price at that time).  They inherit the entire $3,930,052 without a penny of taxes owed against it, the $1,292,000 that would have been owed to the government is forgiven entirely.

6. Take Advantage of the Unique Tax Benefits of Certain Assets, Securities, and Investments

From time to time, Congress offers special rules on certain types of investments to incentivize the market.  There are several tax advantages to Series EE savings bonds that might not do any good now, thanks to our world of near zero-percent interest rates, but could someday in the future.  Certain hard assets, such as oil and natural gas pipelines, held through master limited partnerships, or MLPs, might allow you to shield a significant percentage of the cash distributions paid each year using depreciation charges.

7. Take Advantage of Annual Gift Tax Exclusions, Possibly Using a Family Limited Partnership with Liquidity Discounts to Give More Assets Than Would Otherwise Be Possible

Each year, the law allows individuals to give away a certain amount of money without paying gift taxes.  At the moment, in 2017, the limit is $14,000 per person.  That means if you are married, you and your spouse can jointly give someone else $28,000 without tax consequences to you or the recipient.  For individuals or couples over the estate tax limits, making annual gifts of stocks, bonds, real estate, and other investments to your family members can take a huge bite out of the death taxes you would have otherwise owed.

Even better, there are well-established ways that working with qualified advisors you might be able to take advantage of something known as "liquidity discounts", wrapping up assets in a family limited partnership and giving more wealth away each year by applying lower-than-market values to the holdings.