A key component of effectively serving high-net-worth investors is managing the impact of taxes on their wealth. Affluent investors often have more complex and nuanced financial circumstances, which can lead to significant tax implications.
Taxes are often listed as one of the biggest concerns of this segment of investors — and for good reason. In the US in 2020, the top 1% of income earners accounted for 22.2% of all household income before taxes — however, they paid approximately 42.3% of all federal income taxes.¹ To serve high-net-worth clients, financial advisors should focus efforts on comprehensive tax planning strategies to help them optimize wealth and minimize taxes.
Effective tax planning for high-net-worth investors can have potentially far-reaching impacts — from preserving wealth to enhancing investment returns to growing assets. Every investment decision should be made through the lens of potential tax implications and executed accordingly. And because tax laws are ever-changing and limits shift from year to year, advisors who are well-versed in tax planning strategies can bring significant value to their clients.
Let’s look at some of the most common tax planning strategies that advisors can consider for high-net-worth clients.
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Take Full Advantage of Tax-Advantaged Retirement Accounts
Tax-advantage retirement accounts — such as 401(k)s and IRAs — are a highly accessible way to proactively invest for tax benefits. Depending on the type of account, they can provide multiple layers of tax benefits, including:
- Less taxable income: Certain types of retirement accounts allow pre-tax contributions. Investors who maximize their allowable contributions are effectively lowering their total income for tax purposes.
- Tax-deferred growth: Certain types of accounts, such as 401(k)s and IRAs, enable assets to accumulate on a tax-deferred basis. That means that taxes can be deferred on the growth of the account until it’s distributed. Investors can access those assets when they are either earning less or otherwise in a lower income tax bracket.
- Tax-free withdrawals: Certain types of accounts, such as 401(k)s and Roth IRAs, also allow for withdrawals and distributions to be taken free of income taxes.
- Roth IRA conversions: Depending on their overall tax situation, some investors may benefit from converting traditional retirement accounts into Roth accounts, potentially paying taxes now in exchange for tax-free withdrawals in the future.
Investors with specific funding goals, such as education costs, can leverage 529 plans to set funds aside, allow them to accumulate tax-deferred, access them to pay for qualified education expenses, and in some cases, avoid paying taxes on assets used.
Manage Gains and Harvest Losses
Within any investment portfolio, there are multiple ways to optimize investment gains and losses for tax purposes.
- Offsetting gains and losses: Investors can strategically time the realization of capital gains and losses to offset each other to reduce the tax liability whenever possible.
- Donating assets: Highly appreciated assets can be used as charitable donations and avoid the liability of the capital gains tax. We’ll talk more about this in the charitable section below.
- Timing the realization of gains: If there’s a year where a client’s income tax burden is lower — perhaps they made large charitable contributions, changed jobs, dropped into a lower tax bracket, or some other reason — they may want to realize capital gains on an investment during that year.
- Spreading out gains: Investors wanting to sell a highly appreciated asset can unwind their position over the course of several years, stretching out their tax consequences.
- Harvest losses: Harvesting is a way to turn an investment that has lost value into a positive. Investors can use the loss from the sale of one investment to offset the gain from another investment so that the end result is a lower overall tax consequence. When harvesting losses to offset gains, short-term losses must first be used to offset short-term gains and long-term losses must be used to offset long-term gains. After all the available losses have been used to offset in-kind gains, investors can use any remaining excess losses to offset any remaining gains. If there are any remaining losses, they may be used to reduce ordinary income tax or roll a portion over into the following year. During a down year, such as 2022, realizing a loss can be effective even if no capital gains were realized and unused losses can be carried forward indefinitely.
Pay Attention to Asset Selection, Location, and Allocation
When constructing investment portfolios for high-net-worth clients, the selection and location of assets are critical in creating tax efficiency. Clients looking for ways to manage taxes should explore investments that generate lower levels of taxable income, such as tax-free municipal bonds, and holding investments for longer periods of time to qualify for lower long-term capital gains rates.
Creating a diversified portfolio can help manage both risk and tax implications. The more diversified, the potentially smoother the volatility, helping to even out swings that could mean large capital gains.
Where assets are held can help optimize an investment portfolio for tax efficiency, such as:
- Allocating more tax-efficient investments: Those with lower capital gains and tax rates — in taxable accounts.
- Allocating less tax-efficient investments: Those that are more volatile and may generate higher tax liabilities — in tax-advantaged accounts.
The best location for any investment is highly dependent on the client’s risk tolerance, time horizon, distribution timeline, and other factors, as well as the tax characteristics of the security.
Be Charitable
Another common way for high-net-worth investors to lower their taxable income and maximize tax advantages is through philanthropy. Advisors with high-net-worth clients can work together to develop a charitable giving strategy that can be executed in a number of ways.
- Donating appreciated assets: Many non-profit organizations accept securities as a donation. Investors who donate a stock that has been held for at least a year and has appreciated can avoid paying capital gains taxes on that stock, as well as deduct the fair market value of the asset. This helps maximize the donation as opposed to liquidating the asset, which would incur a long-term capital gains tax, and donating the remaining after-tax funds. In most cases, the receiving organization can liquidate the stock without a tax liability.
- Donor-advised funds (DAFs): These are charitable giving funds that individuals, families, or organizations can contribute to and are managed by a charitable sponsoring organization. This means donors can advise on how the assets are invested and distributed but do not manage the fund. DAFs offer flexibility in that donations can be made as often as the client chooses, donations can be made using cash or securities, and clients can take a tax deduction for the year, even if the actual donation is spread out over future years. In 2021, there were over a million DAFs to choose from² and donors contributed over $73 billion to them.³
Keep it in the Family
There are several gifting strategies that HNW clients can use to transfer wealth to family members and help minimize estate taxes. The most common is through the use of trusts. Trusts can either be revocable — meaning that they can be revoked or amended after they are established, or irrevocable — meaning they cannot. Revocable trusts, depending on the parameters, may or may not lead to tax advantages. Irrevocable trusts, because they cannot be changed, offer greater potential for tax advantages. HNW investors often use irrevocable trusts to transfer assets to avoid those assets from being subject to estate taxes. Contributions to irrevocable trusts up to a certain limit can be made without being subject to a gift tax.
Consult with Estate Planning Experts (or Be One!)
Careful estate planning is essential for HNW investors. Without it, gift, estate, and generation-skipping taxes, often referred to as wealth transfer taxes, can have a significant impact on an individual’s wealth. To further complicate estate planning, in addition to federal tax regulations, states may have their own laws that can impact plans. It’s imperative for advisors to either specialize in estate planning services or partner with someone who does to help ensure affluent clients are protected from unnecessary tax consequences.
Advisors and their high-net-worth clients have multiple planning strategies to help manage the impact of taxes on wealth. As tax laws and limits constantly change, advisors must make sure they are fully informed and help clients use any available tax credit and deduction opportunities and note that the effectiveness of any strategy can vary based on individual circumstances.
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