High-net-worth individuals who are in the highest tax bracket should implement an investment strategy to avoid tax traps.
“Tax planning is a crucial aspect of financial management, especially for high-net-worth individuals,” says Gary G. Isakov, CPA, a Senior Client Advisor at CM Wealth Advisors. “With substantial assets and income, they face complex tax scenarios and higher tax liabilities. Effective tax planning can help mitigate these liabilities, ensuring wealth preservation and growth.”
Smart Business spoke with Isakov about tax considerations for high-net-worth individuals.
Why is the tax situation unique for high-net-worth investors?
High-net-worth individuals are typically defined as those with investable assets exceeding $1 million, excluding primary residences. This category often includes entrepreneurs, executives, investors and inheritors of large estates. Due to their significant financial resources, they encounter unique tax challenges and opportunities that those in lower tax brackets may not face.
What are some tax planning options for these individuals?
Income tax optimization is one strategy by which high-net-worth individuals can reduce their overall tax burden by shifting income to family members in lower tax brackets. This strategy involves transferring or gifting income-generating assets, such as stocks, real estate, operating partnerships or LLCs to children or other relatives.
For those who must take a Required Minimum Distribution (RMD) from their retirement accounts, the IRS allows a Qualified Charitable Distribution (QCD) of up to $105,000 per person that is made directly to a charity. This is a powerful tax play for those who are charitably inclined because it allows for exclusion from taxable income while counting against the RMD, potentially saving more than 40 percent of the QCD in federal and state taxes.
Roth IRA conversions have become a ‘hot topic,’ as tax rates are expected to increase after 2025. Those that expect to be in a higher tax bracket during retirement may want to pay the lower tax now. Taxpayers that have favorable tax attributes, including a high basis ratio, charitable deduction carry-forward, investment tax credits and net operating losses should consider a conversion, as these attributes reduce the effective tax rate of the conversion.
Taxpayers who can pay the income tax on the IRA from non-IRA funds benefit greatly from the Roth IRA because of the ability to enjoy greater tax-free yields by moving funds from a taxable to a tax-free asset class. There are no RMDs during the account holder’s lifetime. Post-death distributions to beneficiaries also are tax-free, which is possibly the most advantageous aspect of a Roth conversion.
To manage capital gains, investors in private companies should consider investing in companies that would qualify for Section 1202 tax treatment. This could eliminate or significantly reduce any eventual tax gain. A number of private equity investments qualify for 1202 treatment. Additionally, if applicable, selling a closely held business to an Employee Stock Ownership Plan (ESOP) is a great way to defer or significantly reduce the tax consequences of a business sale. Finally, consider ‘capital loss harvesting’ or selling investments at a loss to offset gains from other investments to reduce taxable income. This strategy can be particularly useful in volatile markets.
When it comes to estate and gift tax planning, establishing an irrevocable trust can remove assets from an estate and reduce estate taxes. Trusts such as Grantor Retained Annuity Trusts (GRATs) or Charitable Remainder Trusts (CRTs) can be effective tools. The latter is a great way to get a current deduction but ensure an income stream for life with the remainder going to charity. This is a beneficial strategy for those who are philanthropic.
Who can help?
Effective tax planning involves a multifaceted approach, balancing current income tax strategies, capital gains management, estate and gift tax planning, and charitable giving. Working with experienced professionals — financial planners, tax advisers and estate attorneys — to employ these strategies can allow high-net-worth individuals to enhance their financial well-being and secure their wealth for future generations.
INSIGHTS Wealth Advisory is brought to you by CM Wealth Advisors.
