How to Be Smarter About Investment Taxes

We all recognize that taxes are a perpetual reality (as Benjamin Franklin once famously said, “…nothing is certain except death and taxes”). However, it’s essential to understand how taxes impact the profits your investments generate.

Let’s take a deeper dive and review several strategies that maximize after-tax wealth creation.

• Paying taxes should not be considered a “bad thing” as their goal is to help society function well. The key is to consider the tax cost of an investment with the goal of maximizing after-tax gains.

• You can significantly save money by following simple tax minimization strategies.

• Some tax strategies that reduce flexibility may not be worth the cost. As an example, if you and your family are unable to tap into a portion of your net worth due to investments in tax-sheltered structures, this limits your freedom and the usefulness of your wealth.

• You should avoid tax strategies that violate the spirit of tax laws. Overly aggressive tax strategies can bring financial, reputational, and legal risks to you and your family.

Investment Strategies

Buy & Hold or Low Turnover

Investments can generate income, both realized (taxed) and unrealized (tax deferred).

An investment with high trading frequency can generate substantial realized gains and losses and cause you to pay additional taxes for the year those gains were realized.

A low turnover portfolio minimizes an investor’s tax burden by reducing the sale of assets that crystallize gains or losses.

One of the ways investors get hit with unexpected taxes is when they invest in higher turnover strategies managed by illiquid investment funds. By illiquid, we mean it’s not possible to redeem your interest in the fund for cash.  In this case, the fund may generate a tax liability for you but not allow you to withdraw capital from the fund to pay those taxes.  Instead, you will have to pay those taxes from your savings or other earnings. 

It is more efficient to do active trading strategies in tax-exempt vehicles, like retirement accounts and charitable accounts, such as Donor Advised Fund accounts (DAFs) or private foundations.

Real Estate

Here are four elements of investing in Real Estate that can generate favorable tax treatment for investors:

• Depreciation

• Interest Expense

• Refinancings

• 1031 Exchanges

Depreciation and interest expense can shelter income from a real estate investment. It may render rental income entirely tax-free during a particular year.

Adversely, depreciation reduces an investor’s cost basis in the property by the same amount of cumulative depreciation.  When an investor sells the property, they will have a higher capital gain with more associated taxes.

To the extent that an investor is not looking to sell the property, they can withdraw capital from an investment by refinancing the property for a larger loan balance. This is not a taxable event in many states, so one can continue to take principal out of an investment, tax-free. 

Further, if an investor is seeking to dispose of the property, they can avoid taxes by conducting a 1031 exchange—this allows the investor to use the proceeds of the sale to purchase a new property without paying the capital gains tax. Many real estate empires have been built on this piece of the tax code, where investors have been able to forgo paying realized capital gains for decades or generations.

Philanthropic Giving

The US tax code highly incentives philanthropic giving by allowing the giver to deduct the market value of their gift for the tax year when the donation was provided.

There are vehicles, like DAFs and Foundations, that allow a family to continue to influence the charitable assets, both in investment strategy and in granting once the gift is given. Our founder, Aseem Garg, and his wife donate to a DAF, The Aseem & Anjuli Garg Family Fund. For more than a decade they’ve been using this DAF vehicle to grant funds to charities they strongly believe in.

Through the lens of viewing charitable assets as part of your net worth, donating a highly appreciated security enables an increase to your net worth by reducing taxes paid in the current year, reducing the liability from long-term capital gains, and increasing the amount of capital in the charitable account by the total market value of the gift.

Retirement Funding

The US tax code also encourages retirement savings (401K or IRA) by allowing you to put pretax capital into a traditional retirement vehicle or putting post-tax money into ROTH vehicles that will not be taxed post the retirement age.

These vehicles are high flexibility because the penalties for early withdrawals (~10%) are not egregious.

Exceptions are offered in times of economic turmoil that eliminate or reduce these penalties.

Tax-Advantaged Investment Vehicles

Municipal bonds and Opportunity Zones are two investment types that have favorable tax treatment. For many municipal bonds in a particular state, the coupons paid are tax-exempt from federal and state taxes.

Opportunity Zone investments can be fully sheltered from taxes if held for a long enough holding period (10+ years). This introduces a fair bit of illiquidity, which can be mitigated if the properties distribute capital during your holding period.

Corporate / Business vs. Personal Expenses

Personal expenses are paid from post-tax dollars. If you can claim an expense for business purposes, that expense becomes partly or wholly tax-deductible—more efficient.

Health Care Savings Accounts

These accounts are funded by pre-tax dollars and can grow tax-free. These accounts are valuable because healthcare costs, which include dental, vision, and medical, can be very high, and you can use funds from these accounts for current medical expenses.

Education Funding

There are a few tax-advantaged ways to save for children’s education expenses. These are generally 529 plans. Depending on the U.S. state from which the plan originates, there are some restrictions about how you can spend these funds (post-secondary education only in certain states, while others allow private school expenses)—and investment options are generally limited. That said, gains from 529 plans are tax-free when used for education purposes, as defined by the state’s rules.

529’s are appropriate for families whose net worth is not expected to exceed the lifetime gifting exemptions, which (for a married couple who are U.S. citizens) is currently $26M and expected to drop by 50% in 2026.

Estate and Inheritance Taxes

In the coverage of Education Funding, the concept of lifetime gifting exemptions was introduced.  Currently, for a married couple, it’s possible to pass on up to ~$26M without paying any federal estate tax.

The Federal tax code contemplates a deductible floor on your estate, also known as the federal estate tax exemption, whereby any value more than the exemption is taxed at 40%. This exemption amount is equal to the lifetime gifting you transfer throughout your life to others – like your children.

One caveat to the gifting limit is the annual individual gift limit which is currently (in 2023) $17K. You may give $17K this year to as many individuals as you desire without affecting the lifetime gifting exemption. Our founder, Aseem Garg, and his wife opted to pass capital down to the next generation via custodial accounts, gifting the annual limit to each child, which becomes wholly owned by the children at the age of 21. There is no specific income tax advantage to that approach, but it moves capital out of their estate (reducing the estate tax burden) and allows unrestricted investing.

Finally, several states impose either their own estate tax, and/or an inheritance tax imposed on the person receiving the estate from the deceased. It is important to consider all these factors. They can have low exemption limits and can be significant.