How to save $175,000 in taxes
Advanced tax cutting strategies & tax efficient investing
The challenge
Tax rates for high-income earners have gone jumped in 2014 leaving many investors scrambling to adjust to much higher tax bills. A client who earned over $600,000 a year in employment income also had a large investment portfolio and nearly $100,000 of income from a commercial real estate rental. How can a client making nearly a $1 million of income who is subject to a top 39.6% federal tax rate, a top 13.3% CA tax rate, and the new 3.8% Medicare tax rate on investment income cut his tax bill?
What we did
As a W-2 employee of a large and publically traded corporation, there is little we can do to minimize or delay tax on his employment income. In a large company, there are few options an employee has to defer or shift income. However, we are speaking with the company’s HR department about the benefits of adding a non-qualified deferred compensation plan. If the company does add a non-qualified deferred compensation plan, our client may be able to defer payment on some of his salary – thereby spreading the income over several years and also paying a smaller effective tax rate. But whether the company offers a deferred compensation plan is largely beyond our control. Fortunately there are things we have control over that can directly decrease our client’s taxes.
We start with the commercial building that generates monthly income. Because our client has a large (and taxable) estate, we are always focused on minimizing the growth of his estate that will be subject to estate tax. We anticipate that the commercial building will continue to appreciate within his estate, so our goal was to move some of this appreciation out of his estate and to his children. Years earlier we helped the client establish a family limited partnership to shift part of his company outside of his estate. We then had him and his wife do annual gifting to his children – passing some ownership of the commercial building from his estate to his children through the family limited partnership. This had a dual effect – it partially removed some value of the building from his estate, it removed any additional growth of the building his children now owned from his estate, and it shifted some of the rental income to his lower-tax bracket children.
Next, we re-allocated his investment portfolio. We started by taking high taxable income producing bonds and shifted much of this allocation to CA municipal bonds, which are not subject to federal, state, or the 3.8% additional Medicare tax. We also shifted tax inefficient investments (e.g., taxable corporate bonds, emerging market debt, REITS, MLPs, high turnover stock funds) to his retirement accounts since these accounts pay not annual income tax and shifted the growth oriented investments (e.g., stocks, private equity) to his taxable trust account.
The outcome
- Instant annual tax savings of approximately $175,000.
- Completely avoiding the new 3.8% Medicare tax on his investment income
- Reducing the 3.8% Medicare tax on his rental income (a small portion of the building rental income that wasn’t transferred to the family limited partnership and that he still owns will be subject to this tax)
- Estate tax savings are unknown, but if our client lives to full life expectancy and the building continues to appreciate, we would anticipate an estate tax savings of at least six figures.
These examples are for illustrative purposes only. Any strategies referenced herein do not take into account the investment objectives, financial situation, or particular needs of any individual. They should not be considered individual advice, suitability must be independently determined. Individual results will vary and may be more or less favorable than in the examples shown.
