As we approach the end of 2013, affluent families are considering their tax situation. This is the right time of year to do so. However, most people think of taxes in relationship to ordinary income. I believe it is time for a mind-shift. I believe it is time for affluent families to look at their investments, not just ordinary income, in relationship to taxes.

Why do I say this? In 2013 we witnessed many changes both to legislation and to the markets that will likely impact your tax picture. I do not believe that we have seen the end of these changes.

Wealthy people are now facing significantly higher federal taxes in addition to, in many states, much higher state income taxes on their investment income. Federal taxes on investment income could be as high as 39.6% for the wealthy.

In addition, the “Obamacare Medicare tax” could add an additional 3.8%. With state taxes as high as 12%, the tax on profits could be well over 50%. With the enormous amount of debt at both federal and state levels, together with unfunded federal liabilities for Social Security and Medicare, it is very likely that these taxes will move even higher.

Clearly, not paying attention to the tax effects of investment transactions could lead to very painful results. I believe it will become increasingly difficult for people to build their net worth if they do not adopt a plan to make their investing tax efficient. 

How can you do this? Here are four tax mitigation strategies that you should carefully consider.

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"I take great pleasure in helping my clients find better and more tax efficient ways to pass their wealth on to the ones they love and the charities about which they are passionate."


Be cautious with large investments that pay year-end dividends

You should be careful of making large investments towards the end of a year, especially in years like 2013 when the equity markets are up over 20%. Mutual funds generally pay their dividends at the end of the year. So if you bought a fund in December, you could get surprised having to report a very large taxable gain for that year that was earned, not by you, before you acquired the fund.

Investors should contact the mutual fund company to request an estimate of the yearend dividend that will be paid. In most cases, the fund company will provide that information to you.


Structure investment accounts for tax efficiencies

Make sure your investments are held in appropriate investment vehicles for tax mitigation purposes. Most people have their investments in a variety of places. They may have tax sheltered plans, like a 401k plan or an IRA account. They may also have money in their personal investment accounts where the income is not sheltered from tax.

Some investments generate an inordinate amount of ordinary income that is taxed at the highest rates. It would be most efficient to buy these types of investments in one’s IRA or 401k account. This will shelter this income from tax until it is distributed, hopefully when they are retired and in a lower tax bracket.

Other investments are taxed favorably and generate little or no current taxable income or generate income that receives a favorable tax rate (like dividends and capital gains taxed at 15%). Some investments generate no current taxable income. These should not be bought in an IRA or a 401k account but in one’s personal account.

A good example would be gas pipeline companies whose current dividends are not taxable but rather treated as a return of capital. Each mutual fund manager can provide a prospective investor with the information about their fund and the type of income that is generated. 


Consider new insurance products as tax efficient investment options

As a direct result of the increase in federal and state taxes on investment income, many new investment products are being developed to mitigate the impact of these higher taxes on very wealthy people.

Insurance has always been a tax favored investment. Generally, the proceeds of a life insurance contract are tax free to the beneficiary. Annuities accumulate tax free until such time as the owner starts withdrawing income. But, insurance annuities and life insurance policies often can be burdened with very high costs for administration, commissions and premium taxes.

Competition amongst insurance companies has created a new type of product called private placement insurance. These new policies provide investors the opportunity to acquire a life insurance policy that will allow them to invest in many types of investments, including hedge funds, global bonds, commodities, stocks, real estate and others.

In most cases, these new products are low-cost with reduced commissions and lower insurance costs. Even though these are life insurance contracts, they allow the owner to take distributions during their lifetime that are not taxable. These new products tend to be very complicated. Unless the potential investor is financially sophisticated, he or she may need the assistance of one or more professionals to analyze whether this would be appropriate for them.


Carefully evaluate the tax implications of active investing

For years there has been a debate about whether active investment strategies or passive investment strategies will produce better economic results for clients. Also, there has been a growth in new investment products like hedge funds that are aimed at outperforming the market.

Active strategies involve higher fees than passive strategies and they also involve trading in and out of various investments (stocks, bonds, commodities, etc.). Current tax law reduces and even eliminates in most cases the deductibility of those higher fees. Also, active trading usually entails generating taxable profits as either short term or long term gains.

With the higher tax rates I discussed earlier, there will be a greater challenge for active managers to outperform passive strategies (using index funds). This does not mean that passive strategies will always outperform an active manager. It does mean that active managers will be challenged to match the returns of passive strategies after taking into account the higher taxes that will be generated by active trading.

My advice is to have your advisor evaluate the track record of your managers taking into account the tax costs that their strategies incurred in producing their track record.


Next steps

Taxes are becoming a significant burden to wealthy families. I recommend that you learn more about how taxes will impact your unique situation so you can actively work to become as tax efficient as possible. I do believe that those who do not make tax considerations a primary driver in their investment choices will be sorely disappointed with their results over time.

If there is anything we can do to help you improve your tax efficiencies, please contact us for an exploratory conversation.



You should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized financial planning and/or personalized investment advice from Whitnell & Co. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he/she is encouraged to consult with the professional adviser of his/her choosing.

Any hypothetical examples included in this article are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.