Most investors focus on generating cash flows, long-term growth, or a combination of both. But some investments may have another special benefit: 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 deduction to sweeten the deal. Depending on your income, tax bracket, and investment size, 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 fairly tax-advantaged asset class. For most ordinary families, their primary residence is likely their best source of tax-free investment earnings. Not only are profits from the sale of your primary residence tax-free up to $250,000 for single filers ($500,000 for joint filers), but the monthly interest on your mortgage is also tax deductible, up to certain amounts (1).
Some of these benefits don’t apply to investment properties, but that doesn’t necessarily mean you’ll have to pay more taxes for ownership. According to the IRS, mortgage interest, property taxes, operating expenses, depreciation, and repairs can be deducted from the rental income you earn from your property portfolio (2).
Sophisticated investors also use a 1031 exchange to defer capital gains taxes when selling investment properties (3). Simply put, it allows real estate investors to sell one investment property and reinvest the proceeds in 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 are a wealthy investor in a high tax bracket, this asset class should top your list.
By purchasing a municipal bond, you are offering capital to your local city or state that can be used to build schools, roads, or sewer systems. So, to encourage this flow of capital to your local community, interest earned on municipal bonds (also known as municipal bonds) is generally exempt from federal taxes (4).
In some cases, the tax exemption is also at the state and local level. This makes them exceptionally attractive to high-income households. According to the Bipartisan Policy Center, 70% of the tax-exempt interest earned in 2022 was captured by households earning more than $200,000 a year (5).
However, you don’t have to be in the top 10% to enjoy the tax-free income from these special bonuses.
Read more: Are you richer than you think? 5 clear signs that you are head and shoulders above the average American
Health Savings Accounts (HSAs) offer investors a rare triple(6) tax advantage. Not only are your contributions to this account tax deductible, but you can also defer taxes on any growth in the account and withdraw it tax-free as long as the money is used for qualified medical expenses.
Unfortunately, contribution limits are relatively low (7). But if you contribute regularly and consistently, this account could represent a powerful long-term tax savings.
If you and your family are wealthy enough to be able to support some charitable causes, a Donor Advised Fund (DAF) might 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 an increasing number of wealthy investors have recognized their advantages (7). Perhaps the most obvious advantage is the upfront tax write-off donors receive while contributing appreciated assets to a DAF.
For example, if you have $500,000 invested in a publicly traded stock, with $250,000 in total gains, the sale would trigger capital gains and a related tax event. This ultimately reduces the amount of money you receive after taxes.
However, depositing this equity 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 finally being distributed, tax-free, to registered charities over several months or years.
Not only does this allow you to recognize a large tax deduction, but it also increases the amount of money you leave to charities. In other words, it is the most effective 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 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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Treasury (1; 2; 7); Turbotax (3); MSRB (4); Bipartisan Policy Center (5); Charitable Fidelity (6)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
