• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Briefs>Permanent Tax Savings and Techniques

Related Content

  1. Videos
  2. Articles
  1. How to Fund a Long Retirement

    With mortality improvements, investors planning for a long retirement should consider an annuity, delaying Social Security, and being more aggressive with their portfolio.

  2. Create a Lean, Mean Tax-Efficient Machine

    Morningstar's Christine Benz discusses how to improve your take-home return by reducing the drag of unnecessary tax exposure.

  3. Corporate Tax Number to Blame for Growing Federal Deficit

    Higher payroll tax receipts were not enough to offset weak corporate taxes and higher spending in 2016.

  4. Gotham's Joel Greenblatt on Choosing an Active Manager

    Find someone who has a good process and then sticks to it, says the Gotham Asset Management founder.

Permanent Tax Savings and Techniques

At times, it’s worth deviating from a strategy to save on taxes.

Sheryl Rowling, 10/03/2016

Deferring taxes is typically a good move financially and psychologically, but avoiding taxes permanently is even more beneficial. As an advisor, I believe that a long-term investment strategy should not be compromised for temporary tax savings, but permanent savings might justify a temporary deviation. In this article, I will address the benefits of permanent tax savings and techniques as they relate to investment management.

The goal of permanent tax savings is to decrease taxes so that some or all of the reduction is never paid back to the government. Permanent tax savings can result from one or both of the following:

  • Moving income from a higher tax bracket to a lower tax bracket.
  • Recognizing income without ever paying tax.

Quantifying a “point in time” permanent tax benefit is fairly straightforward. For example, postponing income from a year subject to a 36% tax rate to a year subject to a 15% tax rate results in permanent tax savings equal to 21% of the income. Similarly, holding appreciated securities at death results in permanent tax savings equal to the eliminated tax on the unrecognized gains. Certainly, the “golden ring” of permanent tax savings is worth some effort. Let’s explore the various ways this can be accomplished.

As with tax-deferral techniques, permanent tax savings strategies can be incorporated into investment management through many methods. Advisors willing to dedicate the effort and technology resources can materially have an impact on clients’ current and future tax bills. Below are six permanent tax savings techniques that relate to investment management.

Avoid Short-Term Gains
In general, gains from sales of investments held one year or less are subject to ordinary tax rates while gains from sales of investments held more than one year are subject to long-term capital-gain tax rates. Ordinary rates are typically about twice as much as long-term rates. Therefore, it might make sense to delay a sale for a few days or weeks to achieve long-term status. Of course, delaying a sale could result in a decline in value or a diversification detriment to the portfolio in the interim. These potential costs should be considered relative to the benefit of permanent tax reduction from the rate differential.

Defer Income to Years Subject to a Lower Tax Bracket
Deferring income to a lower bracket year is a similar strategy to postponing sales to achieve a long-term holding period. The tax differential from postponing a sale must be weighed against the potential downsides of decline in value or diversification detriment.

Recognize Zero Capital-Gain Tax Opportunities
When an investor is in a federal tax bracket of 15% or less, capital gains (up to the end of the 15% bracket) are not taxed. In other words, for low-income taxpayers, a certain amount of capital gains are tax-free. Avoiding tax on accumulated appreciation is a permanent tax savings. (We should note that rather than recognizing gains at zero tax, it might be better to take advantage of low brackets by carrying out Roth conversions.)

Hold Appreciated Assets Until Death
The “ultimate” tax elimination occurs at death, when basis is stepped up to fair market value. The long-held belief in the certainty of death and taxes might be only partially correct. Although everyone will pass away, avoiding gain recognition during life can eventually result in a complete escape from taxes. Unfortunately, it is unrealistic to attempt zero-gain recognition during the investor’s lifetime while maintaining a consistent investment strategy. However, as the investor ages, advisors must weigh the relative advantage of strict adherence to the allocation model versus allowing some drift in anticipation of basis step-up.

.

©2017 Morningstar Advisor. All right reserved.