Tax-Friendly Investment Strategies for High-Net-Worth Individuals
High-net-worth individuals do not follow a top-secret investment strategy. They often invest in stocks, real estate, and illiquid investments just like everyone else. However, due to their resources and knowledge, these investors usually know they need to make their money work for them.
Our financial lives are made up of several different areas, such as investments, savings, debt, and taxes - to name a few. Each one of these areas is just one piece of the puzzle, and each can impact the other.
What do the ultra-wealthy know that maybe you and I would like to know? Let's explore tax-friendly investment strategies for high-net-worth individuals.
Who's Considered a High-Net-Worth Individual?
High-net-worth individuals (HNWIs) are people with a net worth of at least $1 million in highly liquid assets. These assets could include cash or investments that convert easily to cash.
Many (though not all) of these individuals also enjoy a high level of income, either from wages or investments, and are generally considered to be financially sophisticated. They may have multiple sources of income and a wide range of investments, including stocks, bonds, private equity, mutual funds, and real estate.
HNWIs often take advantage of tax breaks and tax-friendly investment strategies that are available to them in order to maximize their wealth.
What Is Tax-Friendly Investing?
Tax-friendly investing is really a catch-all term that can refer either to investing in tax-advantaged accounts or to tax-efficient investment strategies.
Tax-advantaged accounts include retirement accounts, such as 401(k)s, Roth IRAs, and IRAs; Health Savings Accounts; 529 College Savings Plans; and more. These accounts generally provide the investor with more of a tax benefit than taxable investment accounts.
Tax-efficient investing involves selecting investments that provide tax benefits, such as deductions, credits, and/or exemptions from taxation. For example, a high-net-worth individual may choose to invest in municipal bonds instead of corporate bonds because municipal bonds can be tax-free.
Tax-efficient investing may also involve the structure and placement of your investments. For example, assets that provide high dividend yields might be placed in an IRA over a taxable account to defer taxation on the annual dividends.
With those definitions behind us, let's consider seven tax-friendly investing strategies.
Strategy #1: Invest in Municipal Bonds
Municipal bonds are issued by state and local governments and their agencies to finance public projects such as roads, bridges, and schools. The money raised from the sale of these bonds is used to finance these public works. These bonds can provide a steady stream of income for investors who are looking for a conservative investment with low risk and predictable returns.
Municipal bonds are generally exempt from federal taxes, and some may be exempt from state and local taxes as well. This can make them an attractive investment for high-net-worth individuals who have large taxable incomes and need to reduce their overall tax burden.
When investing in bonds, it is important to understand the credit rating of the issuer. Municipal bonds are usually rated based on the issuer's ability to repay its debts. A higher rating suggests a lower risk of default. It is also important to compare different municipal bonds to determine which one might provide the best return for your investment.
Be sure you have a clear understanding of if and when municipal bonds will provide value to your overall finances. Often, you can compare the after tax return of an investment to help determine which one is right for you.
Strategy #2: Invest in Tax-Deferred Retirement Accounts
One of the best tax-friendly investment strategies for high-net-worth individuals is to invest in tax-deferred retirement accounts such as a 401(k), Deferred Compensation plan, 403(b), or IRA. These accounts allow you to contribute a certain amount of pre-tax money each year and any earnings will grow on a tax-deferred basis.
This means that you won’t have to pay taxes on the money you contributed or the earnings until you take them out at retirement. Consequently, you may pay less in taxes if you're in a lower tax bracket during retirement. Additionally, since you won't be paying taxes on these funds, it may allow you to invest additional money that you otherwise would not have, allowing our money to grow faster over time.
Strategy #3: Invest in Passively Managed Funds
Index funds, for example, are investments that track a stock index or other financial markets, such as the S&P 500 or Dow Jones Industrial Average. These funds are passively managed, meaning that they are not actively traded and decisions are not regularly made about trying to pick the "right" or "wrong" stocks or time the market. Instead, passively managed funds are designed to mirror the performance of the underlying index and can be used to build diversified portfolios.
Because passive funds often have less buying and selling, they can be more tax efficient.
Strategy #4: Invest in Hedge Funds
Hedge funds may be a classic investment for ultra HNWIs. Using complex strategies, hedge funds are limited partnerships managed by a skilled professional who uses advanced investment strategies to generate alpha results.
With greater flexibility in their investment strategies than traditional funds, hedge funds may be able to take advantage of market inefficiencies and other opportunities. However, it's important to note that hedge funds are generally only available to accredited investors and often require high minimum investments, which can make them less accessible to smaller investors.
Two loopholes make hedge funds attractive to tax-conscious investors. The first loophole is called carried interest, which allows profits to be taxed at the capital gains rate, which is lower than ordinary income. The second loophole is this: many hedge funds set up reinsurance businesses in Bermuda, which charges no corporate income tax. This sets up a complicated international — and fully legal — system radically reduces capital gains taxes.
Strategy #5: Invest in International Markets
Investing in international markets can help to reduce portfolio risk and increase returns for HNWIs. First, because international markets are not strictly correlated with domestic markets, they can balance out volatility. Additionally, investing in international markets can provide exposure to new industries, sectors, and markets that may not be available domestically, which can offer new opportunities for growth and higher returns. Finally, investing in multiple international markets can help to hedge against currency risk.
Investing in certain international markets may allow an American citizen to claim the Foreign Tax Credit. This credit won’t necessarily reduce your overall tax bill, but can help avoid double taxation. Under this rule, if you pay taxes in a foreign country on money you earned in that country, you can count these payments as a tax credit. If the foreign country charges lower capital gains taxes than the U.S., your tax credit reduces your actual tax due. If you paid more in taxes to the foreign government than you would in the U.S., you can usually claim the tax credit for this year and carry over the extra credit to next year.
Strategy #6: Invest in Real Estate
In January 2021, 61.5% of HNWIs said they planned to invest in real estate in the next 12 months. Most of them hoped to earn between 8% and 11% internal rate of return.
One of the most common ways to make a profit investing in real estate is through appreciation (when the property grows in value).
Investing in real estate might include purchasing single-family homes, multi-family dwellings, or apartment buildings as rental units. Buyers may choose to maintain them as rental units or “flip” them to benefit from the price appreciation. Commercial real estate, such as office buildings, shopping centers, and warehouses, may also be a viable option.
When investing in real estate, high-net-worth individuals may benefit from a range of tax strategies. For example, the IRS allows for depreciation deductions for buildings and other tangible assets associated with real estate investments which may offset on a current basis some of the rental income.
Strategy #7: Invest in Private Equity Funds
Private equity is the purchase of non-publicly traded securities such as stock in a privately held company or partnership. Private equity investments are typically illiquid, meaning they can be difficult to sell quickly. They come in several different variations, including venture capital, buyouts, and growth equity. Venture capital funds invest in start-up companies, while buyouts funds the acquisition of public or private companies. Growth equity funds invest in established companies that are showing strong revenue growth and scalability.
The taxes associated with investing in private equity can depend on the type of structure you choose. For example, private equity firms may qualify for the carried interest tax rate, which is generally lower than the tax rate on ordinary income.
Other Tax-Friendly Investment Strategies for High-Net-Worth Individuals
While taxes are inevitable, taking advantage of certain investment strategies can help minimize the taxes due each year. Here are a few more of those strategies:
Tax-Loss Harvesting: This strategy allows investors to offset capital gains with capital losses. This means that if you have investments that have decreased in value since purchase, you can use those losses to offset any gains made on other investments, thereby reducing that year's tax liability.
Charitable Remainder Trusts: For individuals with charitable intent, these are trusts that are set up to provide a steady income stream while also providing tax savings. A donor can put assets into the trust, and when they pass away, the trust will donate the remaining funds to charity. The donor receives a tax deduction for the value of the trust, and the trust itself is free from taxes.
Roth IRAs: A Roth IRA allows investors to contribute after-tax dollars and then withdraw those contributions and earnings at retirement, free from taxes. This is a great way for high-net-worth individuals — and people of more modest means — to save for retirement without worrying about taxes on their income in the future. Check with your financial advisor and tax preparer before funding or withdrawing funds from a Roth IRA, however. There are rules and restrictions that may apply.
529 College Savings Plans: These plans allow investors to save for their children’s college education while receiving certain tax benefits. Contributions to these plans are generally not tax-deductible but they do grow tax-free, meaning that all earnings are not subject to taxation if used for qualified education expenses. Additionally, some states offer a state tax deduction or credit for contributions to these plans. New tax law also allows for potential Roth IRA rollover of excess 529 plan funds. Check with your financial advisor and CPA, as the law can be complex.
These are just a few of the tax-friendly investment strategies that high-net-worth individuals can take advantage of. By doing so, they can potentially save thousands of dollars each year in taxes and get closer to achieving their long-term financial goals.
If you hold a net worth of $1 million or more and would like to talk with someone about how to invest your money in a tax-friendly way, give us a call. Our experienced team of wealth managers would love to help you fashion a strategy that's tailor-made for you.