4 Strategies To Lower Taxes & Build Wealth

Taxes will be your largest expense in life, and you must take them seriously; even more so, if your income is in the higher tax bracket. When you’re planning and deciding to make purchases, you should definitely review the tax consequences before the purchase. I’ll review the following four tax tactics with you that will have a profound impact on your life-long taxes that you must take advantage of!

Low Tax Rates for Billionaires

Everyone has seen the headlines reporting effective tax rates for billionaires, such as Michael Bloomberg (4.1%), Mark Zuckerberg (13.7%), Bill Gates (18.4%), or Warren Buffett (19%). Have you ever wondered how their tax rates are so low and if you could get in on these rates as well? Guess what? The answer is yes. You can also have a low tax rate … if you learn and apply what the billionaires know.

Tax Tactic 1 | Real Estate and 1031 Exchanges

A 1031 Exchange is used when selling one investment real estate property and acquiring another one of like-kind. ‘1031’ is a reference to the Internal Revenue Code – IRC 1031. Typically, you will have owned a property for a period of time, and the value has increased. You would then sell your first property and buy a second one, and not pay taxes on the profits; but there are some rules to follow. This exchange allows you to defer all the capital gains that you would otherwise pay from selling your real estate. You are allowed to defer both state and federal taxes.

Note: You are not eliminating the tax, you are deferring it inevitably.

Tax deferral is when taxpayers delay paying taxes to some point in the future.

See the FAQ if you want more details.

1031 Exchange Example

You buy a property for $3M and sell it a few years later for $6M, and after all of your expenses your profit is $2.5M. For simplicity, let’s say state and federal income taxes would amount to $600k. That’s quite a chunk of cash to simply give away.

Instead, you opt to 1031 Exchange and defer the tax payment. Now you can use the entire $6M for the purchase of your next property. You are essentially getting more buying power, while getting $600K from the government interest free.

Recap of Requirements to fulfill the 1031 Exchange

The requirements in order to fulfill the 1031 Exchange are:

• having to select the next property within 45 days; and
• closing the purchase on the property within 180 days.
• This can also be done in reverse order. You can purchase a property first and then sell the original property.

Hire Your A-Team of Trusted Professionals

In order for your real estate transactions to go through legally and seamlessly, always do your due diligence, research and hire competent, qualified professionals. You should compile an A-Team that consists of a certified real estate broker, attorney, and a certified public accountant (CPA), who are well known and respected in the industry, and you can trust with your real estate transactions. Going cheap on these, is not an option.

Tax Tactic 2 | Retirement Accounts (IRA, 401K, 529, HSA)

There are variations to the benefits of all types of retirement accounts, so I will only cover the basics of why you should have them – potentially all of them.

Investment Retirement Account (IRA)

Investment Retirement Account (IRA) is a long-term savings account that you, having earned income can use to save for your future and enjoy certain tax advantages.

Have you ever heard about Peter Thiel’s Tax-Free $5 Billion Roth IRA? He started a Roth IRA 22 years ago with assets that at the time were worth less than $2,000. His success is far more complex than most people will ever be able to achieve. This example is only to demonstrate the power of compounding and how wealthy individuals shelter their investments.

By placing your money into an IRA, you’re putting money into an investment that you will not use until you retire. Every year, you’ll receive a notice that tells you what your contribution amount is for your IRA. The key is to utilize the contribution to this every year that you qualify for the deduction. The reason this is so powerful is that the money you put into the account is deducted from your Adjusted Gross Income (AGI), thereby reducing your yearly taxable income. You will pay tax on profits, but you won’t pay tax on the deposits.

401(k) Plan

401(k) Plan is another form of retirement account that is employer sponsored. Let’s say your employer matches your contribution dollar per dollar, which means that for every dollar you contribute, they will also put in a dollar. Not all employers match dollar per dollar, so when you come across an employment perk like this, it is something you should highly consider.  Some employers only contribute a percentage or none at all.

A 401(k) Plan is very similar to an IRA, whereas you want to maximize your contributions based on the plan. The upfront contributions to the plan are then deducted from your AGI. Once you reach the age of 72, you start withdrawing your money (it’s mandatory to do so) and then you will be subject to tax on the profits.

The real benefit is that you are reducing your yearly taxes while every year, you’re contributing to the account.

529 College Savings Plan

529 Plan (529 College Savings Plan) is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for education expenses. Every family should plan to have money allocated to their children’s education and started as early as possible. I recommend starting as soon as your child is born to potentially earn as much as possible until the child needs it. The reason being is all the earnings from a 529 Plan are tax free with the exception of a few states – so please ask your certified public accountant (CPA) about tax implications of a 529 Plan in your state. The money deposited into the account is gifted to your child’s account. Ideally, you would start withdrawing money on a needed based on the child’s educational goals and the planned costs.

The great benefit to putting money into a 529 Plan is earning interest on the account from the time your little is born until age 18 when large college expenses come into play. You will not pay any taxes on the interest earnings of a 529 Plan.

529 Example With Compounding

Your child is born, and you start a 529 Plan with a $6,000 deposit. You setup $500 monthly deposits ($6K per year) into that account until they are 18 years old. Let’s assume the Rate of Return is 8%. At 18 years old you will have deposited $114K and the account will be worth $248,826. You will have earned $134,826 in interest, in tax-free dollars.

Health Savings Account (HSA)

Health Savings Account (HSA) is essentially a personal savings account that can be used only for medical expenses. At some point in your life, you will spend money on medical expenses. It’s an unfortunate part of life, but it’s everyone’s reality, and you should be prepared for it. Like a 529, an HSA provides similar tax benefits for qualifying medical expenses. There is a maximum amount that you can contribute to your HSA each year and this contribution should be maximized. You will likely use all of your HSA at some point in your life, but it’s great to have an investment that you will not pay any taxes on the earnings.

The benefits of an HSA can help you lower your taxes, pay for health care more easily and save for retirement. Note that HSAs are only available with high-deductible health plans. You can use HSA funds to pay for eligible health care expenses and for out-of-pocket costs your health plan doesn’t cover. Remember, however, your goal is to not use your HSA as long as you can — in order to accrue maximum tax-free earnings. 

Goal of Retirement Accounts

The goal of retirement accounts is to minimize your tax liabilities. Simple as that – every opportunity you have to reduce your taxes for something that you will need in the future is great. It may seem small and insignificant, but these numbers can become enormous over time and build your wealth, leading to an early, care-free retirement.

Tax Tactic 3 | Using Stocks To Manage Gains / Losses

Familiarize yourself with Tax-Loss Harvesting and take advantage of it when the market has a big draw down to benefit from this amazing tax benefit.

The option of selling securities at a loss to offset capital gains, is typically best to focus on at year-end. However, tax-loss harvesting can be implemented at any time of the year and especially after a large market selloff, which would be an ideal time.

To explain further, here’s a definition from TD Ameritrade,

“Tax-loss harvesting means selling an investment that has lost value and purchasing another security to replace it. Then, the investment loss can potentially be used to reduce the taxes you pay on investment gains you might have, or to reduce your other taxable income, allowing greater potential benefit to you.”  – TD Ameritrade

This only applies to taxable accounts – so do not use tax-loss harvesting in your IRA or other tax deferred accounts.

Exchange-Traded Fund (ETF) is a type of investment fund and exchange-traded product, (i.e., they are traded on stock exchanges).

Tax-Loss Harvesting (or Tax Loss Selling) You can use a capital loss to offset a capital gain within a non-registered account. This maneuver is known as tax-loss harvesting (or tax loss selling). It offers a remarkable amount of flexibility. You can use current capital losses to offset capital gains in the current tax year, and any unused losses can be carried forward to future years taxes.

Tax-Loss Harvesting Example

Last month I sold some of my ETF shares at a substantial loss that I’m actually happy about. I sold an ETF for $100,000 loss and sold another ETF for a $50,000 gain. Subsequently, I was left with a $50,000 loss, so there wouldn’t be any taxable income. I can use $3,000 of the loss this year and carry over the $47,000 to next year. So now I’ve created losses that I can use in the future against my gains.

Don’t forget – over time the markets always go up.

Wash-Sale

The key here is not to create a “wash-sale.” The wash-sale rule prohibits you from selling any investment at a loss and replace it with the same one or even “substantially identical” for 30 days before or after. If you do have a wash sale, the IRS will not allow you to write off the investment loss. Rather than waiting for 31 days to buy your investment back, you can replace one ETF with another. If the ETF you sold was listed in the S&P 500 Index, you could then by one from another issuing company that tracks the Dow Jones Large Cap U.S. Stocks. Since both ETFs are from different companies and track different indexes, you will get a very similar result, but you will avoid having a wash sale. After 31 days, if you aren’t happy with the new ETF, you could sell it and buy back the original one.

Taking losses while staying in the market is an extremely beneficial way to take advantage of your losses and use them against your future gains – all while keeping a very similar performing group of equities.

The Standard and Poor’s 500 (S&P 500 Index) is a stock market index that tracks the stock performance of 500 large companies listed on stock exchanges in the United States.

Tax Tactic 4 | Charitable Donations

You’re probably thinking I’m writing about giving money to your favorite charity to reduce your taxes, right? I am, but there’s a kicker.  One of the most underutilized methods of donation is donating appreciated assets. Yes, you can donate assets such as stock, crypto, or even collectibles. Rather than selling these assets, generating a tax bill for yourself, and donating the cash – just simply donate the asset. When you donate your assets, you get a deduction for the current Fair Market Value (FMV) – or todays actual value of the asset, and you get an exemption from the tax you would have paid on the growth of the asset.

Asset Donation Example

If you bought Apple Inc. stock (AAPL) for $32 (split adjusted) and it’s now valued at $150. Donating the appreciated stock allows you to get the deduction for the FMV and you never have to pay capital gains tax on the appreciation in value. If you’re in California, this would save you 37% if you are in the highest tax bracket.

This same method can be applied to crypto, art, collectibles and other assets using the same rules. This is one of the main reasons that museums are full of very fine art. I will eventually write content on donations and the art world.

Some brokerages have Donor Advised Funds, where you can move your shares into the fund, take the deduction, and allocate the cash to the charity of your choice at a later date.

Think of the Bill and Melinda Gates Foundation. Bill Gates owns shares of Microsoft from the 1980’s that have appreciated at an astonishing rate. He can take his shares and donate them to his non-profit at his original basis and get the fair market value for the donation. This is an incredible tax benefit when used correctly. Next time you’re thinking about donating, think about how you can avoid some capital gains when doing so.

Conclusion

Next time you’re thinking about buying or selling an investment property, or funding your retirement account remember the long term tax savings benefits. You’re on the path and doing the right things. I hope these concepts that I discussed provides you with further insight on how to better understand the tax tactics used by the wealthy, which are available to you as well and will save your hard-earned wealth over the years when applied strategically. Are there any other tax savings methods you’d like to know more about? If you wish to learn more or have particular questions about reducing your taxes using these tactics, please feel free to ask below.

Frequently Asked Questions – FAQ