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Every year, the IRS offers taxpayers a polite warning in the form of what it calls the “Dirty Dozen.” It effectively announces that it knows of about at least 12 of the latest tax-related “scams” (the word used by the IRS) it has observed in the past year, many of which become more popular during filing season. The IRS does not conversely offer taxpayers a guide to the 12 easiest ways to reduce their federal income taxes – legitimately, of course. We therefore introduce “the permissible dozen.”
1. Retirement accounts
Retirement plans have long been an excellent way to reduce and defer taxes. Certain plans, such as traditional 401k plans and some individual retirement accounts, afford a deduction for amounts contributed into the plan. While taxes are ultimately paid when funds are withdrawn, individuals benefit from deferring those taxes and may even pay a lower rate if tax rates decline in the future or if participants fall into a lower tax bracket in retirement. Roth 401k plans and Roth IRAs, in contrast, do not offer current deductions but can offer the ability to escape taxation on all future gains and income.
There is a wide range of other retirement structures that offer similar benefits. They include nondeductible IRAs, simplified employee pension individual retirement accounts, savings incentive match plans for employees, and nonqualified deferred compensation accounts.
2. Medical accounts
Other types of accounts also offer substantial tax advantages. Flexible spending accounts can be used to fund eligible medical and other expenses with pre-tax dollars, while health savings accounts (HSA) can be even more impactful in funding medical expenses while reducing taxes. The three main tax benefits of an HSA are that contributions are made on a pre-tax basis, earnings are tax-free, and distributions (if they are used to pay for qualified medical expenses) are also tax-free.
3. Education accounts
Other examples of tax-advantaged accounts relate to saving for educational expenses, including 529 plans and education savings accounts. A 529 plan is a college savings account that allows for tax-deferred growth and tax-free withdrawals when used for qualified expenses. Similarly, an ESA allows certain individuals to contribute money, have it grow tax-free, and ultimately withdraw it tax-free when the funds are used to pay for qualified expenses.
4. Home ownership
While it generally does not make sense to purchase a home solely for tax purposes, a home can be the ultimate tax shelter for many – the legitimate kind. Subject to limits, homeowners can deduct mortgage interest and property tax payments. Furthermore, homeowners may benefit from certain tax credits and can exclude a substantial amount of capital gains on the sale of their homes.
5. Municipal bonds
Just as one generally should not purchase a home solely to save on taxes, one should not make investment-related decisions solely around taxes. A common way to express this theme is that “the tax tail should not wag the investment dog.” Yet, certain investments, such as municipal bonds, do offer substantial tax benefits worthy of consideration. Interest paid on municipal bonds is typically exempt from federal income tax.
6. Qualified small business stock
If held for more than five years, gain from the sale of qualified small business stock may be eligible for an exclusion of up to 100%, depending on various factors. It may also be eligible for a tax-free rollover if the investor holds the original stock for more than six months and acquires replacement QSBS within 60 days of the sale of the original stock. To qualify as QSBS, the stock must have been issued by a domestic C corporation and satisfy several other requirements, but QSBS can be a powerful shelter for many taxpayers.
7. Tax-aware portfolio management
Other investing strategies can also be powerful contributors to tax reduction. With the same caveat that the tax tail should not wag the investment dog, simply investing in assets designed to produce little or no current income but substantial long-term gains, such as growth stocks, can be effective in deferring and reducing taxes.
Tax-loss harvesting is an especially useful strategy for offsetting taxable capital gains with capital losses by deliberately selling securities that have depreciated in value. Investors can choose to replace the sold securities with similar placeholder securities before reacquiring the sold securities, provided that the “wash sale” rules are followed.
8. Charitable contributions
Taxpayers with philanthropic intent can make charitable contributions to reduce their tax liabilities. Subject to limitations, deductions are available for contributions made directly or through entities such as charitable trusts.
Better still, by donating appreciated securities instead of cash, a donor can avoid paying tax on any built-in capital gains while also generating a deduction based on the value of the donated securities. Donor advised funds and private foundations can make it especially easy to deploy this strategy.
9. Life insurance
Just as buying a home or making investments should not be motivated exclusively by tax considerations, buying life insurance also should not be motivated exclusively by tax considerations. And, as in the case of buying a home or making investments, life insurance can also offer powerful tax savings. To start, the
death benefit on most life insurance policies is exempt from federal income tax. Additionally, for those who need “permanent” life insurance, the cash value inside such a policy is also tax-free in most cases.
For those seeking even more tax leverage with respect to life insurance, private placement life insurance can be a solution for some individuals. PPLI can offer the ability to shelter gains on specific assets that are expected to appreciate dramatically over time. The rules surrounding PPLI are strict and complex, however, so great care is required to use it properly.
10. Qualified opportunity zones
Deferral opportunities are available for taxpayers who generate capital gains and reinvest in qualified opportunity zones. Additionally, if a gain-deferring investment is held for at least 10 years, the gain on that investment is eligible for exclusion.
11. Like-kind exchanges
Other noteworthy strategies include the ability to defer taxation upon the like-kind exchange of real estate, life insurance policies, endowments, or annuities. Again, however, great care is required to execute such an exchange.
12. Business-related strategies
Business owners have many opportunities to reduce their tax liabilities through their companies. In addition to offering the tax-favored accounts described above, many employee benefits, including medical insurance, can be offered with generous tax exclusions. Business owners can also use their businesses to control the timing of income and expenses, offer tax-advantaged equity-incentive structures, and even defer taxes upon selling the business in some cases.
As Judge Learned Hand once famously said:
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more taxes than the law demands: taxes are forced exactions, not voluntary contributions.
The permissible dozen is a safe path to observe the Judge’s wisdom while avoiding the many perils of the dirty dozen.
Michael Nathanson is the chair and chief executive officer of The Colony Group, a national Registered Investment Advisor. Evan Katz is an intern in the firm’s advisory practice.
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