Most investors are focused on either generating cash flows, long-term growth or a combination of the two. But some investments can have another special perk: offsetting income taxes.
To encourage the flow of capital into certain sectors of the economy, the Internal Revenue Service (IRS) offers investors an upfront tax write-off to sweeten the deal. Depending on your income, tax bracket and size of investment, these potential savings could be worth six or seven figures over time.
Strategically adding these investments to your portfolio could supercharge your financial journey. So, here are the top four tax-efficient asset classes and investment vehicles that should be on your radar.
In general, real estate is a pretty tax-advantaged asset class. For most ordinary families, their primary residence is likely to be their best source of tax-free investment gains. Not only are the gains on selling your primary residence tax exempt up to $250,000 for single filers ($500,000 for joint filers), but your monthly mortgage interest is also tax deductible, up to certain amounts (1).
Some of these perks don’t apply to investment properties, but that doesn’t necessarily mean you’ll have to pay more taxes for being a landlord. According to the IRS, mortgage interest, property tax, operating expenses, depreciation and repairs can all be deducted from the rental income you derive from your property portfolio (2).
Sophisticated investors also use a 1031 exchange to defer capital gains taxes when they sell investment properties (3). Simply put, it allows real estate investors to sell an investment property and reinvest the proceeds into another investment property without immediately paying capital gains tax. Instead, those taxes can be deferred — sometimes indefinitely.
Simply put, real estate is one of the most powerful tax shelters in the country and if you’re a wealthy investor in a high tax bracket, this asset class should be top of your list.
By buying a municipal bond, you’re offering capital to your local town or state that can be used to build schools, highways or sewer systems. So, to encourage this flow of capital into your local community, the interest earned from municipal bonds (also known as muni bonds) is generally exempt from federal taxes (4).
In some cases, the tax exemption is also on a state and local level. This makes them exceptionally attractive for high-income households. According to the Bipartisan Policy Center, 70% of tax-exempt interest earned in 2022 was captured by households earning over $200,000 a year (5).
However, you don’t need to be in the top 10% to enjoy the tax-free income from these special bonds.
Read More: Are you richer than you think? 5 clear signs you’re punching way above the average American
Health savings accounts (HSAs) offer investors a rare triple tax advantage (6). Not only are your contributions to this account tax deductible, but you can also defer taxes on any growth in the account and withdraw tax-free as long as the money is used for qualified medical expenses.
Unfortunately, the contribution limits are relatively low (7). But if you contribute regularly and consistently, this account could be a powerful tax saver over the long-run.
If you and your family are wealthy enough to be able to support some charitable causes, a Donor Advised Fund (DAF) could be the most tax-efficient way to do so.
According to Fidelity Charitable, DAFs are one of the fastest growing investment vehicles in the country because a growing number of wealthy investors have recognized their advantages [7]. Perhaps the most obvious advantage is the upfront tax write-off donors receive while contributing appreciating assets to a DAF.
For instance, if you have $500,000 invested in a publicly-traded stock, with $250,000 in total gains, selling would trigger capital gains and a related tax event. This ultimately reduces the amount of money you receive after taxes.
However, depositing this stock investment into a DAF gives you an immediate tax write-off on the market value of this asset. Your assets can then continue to grow within the DAF before being ultimately distributed, tax-free, to registered charities over several months or years.
Not only does this allow you to recognize a big tax deduction, but it also increases the amount of money you leave to the charities. In other words, it’s the most efficient way to donate money.
Depending on your investment strategy and the size of your portfolio, a combination of these four tactics could ultimately reduce the amount of money you leave to the IRS.
A qualified charitable distribution is another tax-advantaged way to donate to charitable causes but you must be 70½ or older to donate directly from your traditional IRA to qualify.
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IRS (1; 2; 7); Turbotax (3); MSRB (4); Bipartisan Policy Center (5); Fidelity Charitable (6)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
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