Op-ed: Here are some savvy tax-efficient investment strategies

Once the clock strikes midnight on Jan. 1, it’s typically too late for someone to do anything meaningful to reduce their tax bill for the previous year.

However, tax season does have a way of getting people thinking about what they can do to limit what they fork over to the IRS.

For most investors, it’s as simple as taking full advantage of their 401(k) plan, using a health-care savings account or opening a 529 college savings plan for children or grandchildren. While none of these things will produce a huge windfall of savings in any given year, the benefits can add up over time.

However, high-net-worth investors have additional — and potentially more lucrative — options. While they would be beneficial moving forward, these strategies are not for 2021 taxes. Let’s take a look at a few of them and also offer the pros and cons of each.

These are complex structures. At a basic level, they allow investors to hold a variety of actively managed, high-growth investments within an insurance wrapper and avoid federal and state taxes on the policy’s cash value.

Naturally, this would be a massive advantage for anyone with investments that typically generate frequent income distributions, such as hedge funds. The theoretical benefits are greatest for investors living in high-tax jurisdictions like California, New Jersey or New York, where aggregate tax rates on investment income can hover near 50%.

The catch is that private placement life insurance requires a significant minimum investment to cover the annual premiums. The cost can often be as high as seven figures over the life of a policy.

The other issue is ensuring that the strategy will pay off. It only makes sense to buy such a policy if the cumulative cost of the annual premiums is meaningfully lower than the tax burden outside the structure. That requires forecasting future investment returns, a task that is fraught with uncertainty. 

Private real estate investment trusts, or REITs, are portfolios of different real estate assets typically concentrated in a single industry, region or both. In theory, this allows REIT companies to capitalize on favorable economic trends unfolding in certain areas of the country, such as the ongoing multi-family property boom in the Sun Belt.

The biggest potential upside of private REITs is that a portion of the cash distributions are often considered a return of capital, which is not subject to taxation. Moreover, such distributions are frequently much larger than those provided by non-traded or publicly traded REITs, which have steeper compliance thresholds to clear and, thus, higher costs.

Of course, one of the reasons private REITs have lower compliance costs (they are not subject to Security and Exchange Commission registration requirements) is also why some choose to steer clear of them. Another downside is that though investors get monthly or quarterly distributions, private REITs are illiquid, having lockup periods lasting from seven to 10 years. Finally, the annual fees usually run between 1% and 2%.

You must be an accredited investor to access a private real estate investment trust (That’s the case to purchase a PPLI policy, as well, but their costs make that somewhat of a moot point). Yet, that’s not as high a bar as it used to be for individuals.

According to one estimate, more than 13 million people in the U.S. today meet the standard: an income of more than $200,000 ($300,000 for couples) the past two years or a net worth of $1 million or more.

For charitably inclined individuals, this is an excellent way to defer or mitigate the impact of taxes on highly appreciated assets.

Here’s how it works: A donor places an asset within an irrevocable trust and designates a qualified charity as the beneficiary, structuring the trust to provide a revenue stream for themselves or someone else. It could be for life or a set number of years. The timeframe will depend on income needs.

When the donor funds the trust, they can claim a charitable contribution deduction for that year (up to 30% of adjusted gross income for securities and 60% for cash). Plus, they can carry forward any unused deduction for up to five years.

Also, because the distributions come over time, the donor can defer taxes on the assets within the trust until they retire. Ideally, this would allow them to collect much of that income when their tax rate is much lower.

As with most things, there are opportunities and obstacles to any tax strategy, no matter how wealthy someone might be. All of which underscores the importance of having access to a professional who appreciates the nuances of the options mentioned above. One misstep could be very expensive.  

— By Andrew Graham, founder and managing partner of Jackson Square Capital