The acronym (HNWI) is often used in the financial industry to identify someone who has liquid assets of at least $1 million after accounting for their liabilities. Liquid assets are cash and investments that can be easily liquidated or converted to cash. Such a person is identified for specialized wealth management services due to their net worth.
The more wealth a person has, the more work it takes to maintain and preserve that wealth. This includes a strategy called tax planning, where an HNWI will consult with a tax professional or wealth management advisor about multiple ways to reduce taxable income or better utilize allowances in the tax laws to minimize tax liability.
Sometimes the tax planning strategies adopted by professionals can be aggressive, focusing on the application of a number of strategies that effectively defer taxes indefinitely, or plough the resources into reinvestment strategies.
For the IRS it is a continual challenge to monitor and crack down on aggressive tax planning (ATP) because it affects the amount of federal, state, and local taxes available and therefore affects government initiatives at all levels.
Ideal strategies are more moderate than ATP and are fairly applied - where HNWI don’t have to watch all their wealth get siphoned away by government spending, but also play a role in the management of the country as responsible citizens.
What qualifies as tax planning for HNWI?
Tax planning for HNWI extends beyond the utilization of a health savings account, a donor advised fund, or even a tax deduction. It is a highly tailored approach that evaluates personal, business, and estate-level tax considerations. The goal is to leverage available tax codes effectively without crossing ethical and legal boundaries.
Without the benefit of any tax planning strategies, HNWI are susceptible to high taxes. For instance, an HNWI with an annual taxable income of only $578,125 ($693,750 for married couples filing jointly) will part with 37% of their income.
This is not as high as several other countries across the globe, with the Ivory Coast leading the pack at a tax rate of 60% for high-earning individuals, but it's still 37% of your wealth in government coffers. Also, this does not include state or local taxes. [1]
Aggressive tax planning
ATP on the other hand can include strategies such as setting up complex offshore entities with minimal operational substance or intricate loan-back schemes to avoid income recognition.
While technically defensible at times, these strategies often attract scrutiny and potential fines when they are deemed to lack economic substance.
The Law Center recently published an amicus brief in a pivotal case before the Tax Court, Patel vs. Commissioner of Internal Revenue, which threatens to weaken the ‘economic substance doctrine’. According to medium.com, Economic substance doctrine is a tool of statutory interpretation developed by judges when confronted with taxpayers claiming tax benefits based on tax-avoidance schemes structured to comply with some narrow aspects of the letter of the tax code, while at the same time generating tax benefits that Congress did not intend. [1]
Under the auspices of this case and others, the IRS is increasing its enforcement efforts. For this reason, it's critical to be both financially and socially responsible when it comes to tax planning.
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Never considered having a professional tax planning session with an experienced CPA? Then now is the time to change that. Hall Accounting Company has been working with HNWIs to not only save on taxes but to invest in the things they love to do. All you have to do is schedule a consultation with us, and we’ll get to work on wealth creation and protection strategies that will secure your financial future.
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The question is, how can you strike the kind of balance we’ve been alluding to, where you’re satisfied with a portion of your wealth going to aid federal initiatives in favor of the disadvantaged, and keeping a portion to grow your personal and family wealth?
The answer is to employ moderate tax planning strategies that benefit you and don’t attract the scrutiny of the IRS.
Previously, in an article titled, High Income Tax Planning: Proactive Strategies for Tax Relief, we discussed ten effective tax relief strategies for high income earners.
What follows here builds on those strategies by looking at practical examples, allowing you to visualize the effectiveness of the most effective options.
7 Tax planning strategies and their benefits
Wealthy individuals intently spend, move, and invest money to reduce tax liability, and these adopt one or more of these approaches.
1. Retirement accounts
The tax planning focus of retirement accounts is a reduction in taxable income today and growth for these accounts, while you will only pay tax on these accounts in the future.
Example:
An HNWI decides to maximize their company sponsored 401(k) contribution at $23,000. They also make an additional contribution of $7,500 because they’re over 50.
Simultaneously, they open a Roth IRA contributing $8,000 to allow it to grow tax-free growth and withdrawals. This reduces their income taxes today and in the future.
A Roth IRA is a retirement account that allows you to grow your money tax-free and withdraw it tax-free and penalty free after meeting certain conditions. This is an ideal solution for those who know they’ll be in a high tax bracket when they retire.
2. Investments in taxable accounts
The tax planning focus of investments into taxable accounts is preferential rates on long-term capital gains compared to ordinary income taxes, and a deferment of taxes paid on investment income.
Example:
An HNWI holds $2 million in equities. They strategically sell stocks held for more than one year, paying a 15% or 20% long-term capital gains tax instead of up to 37% for short-term gains. By tax-loss harvesting, they sell underperforming stocks to offset capital gains and carry forward excess losses.
Tax-loss harvesting generally works like this:
You sell an investment that's underperforming and losing money.
Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income.
Finally, you reinvest the money from the sale in a different security that meets your investment needs and asset allocation strategy.
3. Tax efficient vs. mutual funds
The tax planning focus of funds is to minimize the tax bill by investing in tax-efficient ETFs or individual stocks.
Example:
An HNWI $1 million from actively managed mutual funds (prone to high turnover and annual taxable distributions) into low cost ETFs tracking the S&P 500. This allows them to defer capital gains tax until the shares are sold, and to manage the timing of the sale.
4. Health savings account
Tax strategies focused on a health savings account (HSA) are aimed at utilizing a triple tax benefit. Contributions are tax deductible, growth is tax-free, and qualified withdrawals are tax-free.
Example:
An HNWI contributes the 2024 family limit of $8,300 to their HSA. This account continues to grow tax-free if used for medical expenses in retirement, covering premiums and long-term care tax-free.
There are some cautions you must exercise with an HSA. It is not a long-term savings account. Also, non-qualified medical expenses before the age of 65 will attract taxation on the withdrawal and a penalty amount.
5. Charitable contributions
The focus of tax planning for charitable donations is to structure them in the most tax-advantaged way. Many HNWI would rather give money to charitable causes than the IRS because they can invest in things they care about. You can achieve this as follows:
Set up a private family foundation - You can see this as a non-operating charity. It exists solely for holding the wealth you contribute to it. You receive a tax deduction for this contribution.
The only stipulation is that you have to give away 5% of the contributions to qualifying charities. Since this is a private entity, you can hire family members to administer the foundation and pay them a salary, further reducing your taxable income.
Your deduction will be limited to 30% of your adjusted gross income, so be aware of this when you plan the execution of this strategy.
6. Real estate investments
For HNWI, real estate is one of the best tax shelters in the world. This is true for several reasons:
You can deduct depreciation when you buy property
You can accelerate depreciation to reduce the amount of tax you pay
You can sell the property and avoid or defer capital gains tax.
Real estate is one of the only assets that appreciates in value, and that you can generate income with month to month.
Example:
An HNWI purchases a commercial building for $3 million. This building can be depreciated over the lifespan of ownership (sometimes decades).
After 10 years, the building is sold and a capital gain of $600,000 is realized. Instead of paying tax on the gain, a 1031 exchange is utilized by investing the money into a residential apartment. This has resulted in a deferment of taxes and possible rental income.
7. Donor-advised funds
This is a fund usually held at a financial institution which gives you a deduction for contributing to it. You as the donor can direct the fund as to which charity you want your donations to go to. Unlike private foundations, there are no minimum contribution limits.
The downside of this approach is that you cannot hire family members, and you will not be able to deduct certain expenses related to the fund.
Donor-related funds and a number of tax loopholes for business owners are further discussed in an article titled: Tax Loopholes for Small Business: Are They Worth the Risk?
Why you should get the help of a CPA if you’re a high net worth individual
The strategies we’ve been discussing qualify as moderate tax planning strategies that can be applied by most HNWI.
However, setting up these strategies and maintaining them entail a number of rules and regulations. For this reason, we strongly recommend you get the help of a highly experienced CPA.
Without the experience of a qualified financial advisor, you may unintentionally make early withdrawals, transgress contribution limits, and apply investment strategies incorrectly, which could lead to financial losses instead of gains.
You need a partner to help you protect your wealth now and into the future, and Hall Accounting Company can be that partner.
We offer tax planning services for both individuals and businesses. Our strategy is to review every wealth creation avenue possible and work with you on investing in things you care about, protecting your wealth, your legacy, and your family from the growing demands of federal, state, and local tax laws.
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Reference:
2. Medium.com