Why You Need a Tax Efficiency Analysis
At IREXA, we focus on tax mitigation strategies. We help clients mitigate taxes from:
- ordinary income, passive, and portfolio income;
- the purchase and sale of assets including real estate; and
- retirement and estate planning issues.1
First let’s talk about tax mitigation strategies. Tax mitigation is simply the idea of developing strategies that reduce your taxes. To better understand, let’s look at possible sources of income. There are four categories of income: earned income, investment income, which includes passive income, and portfolio income; tax-deferred income; and my favorite, tax-free income.
Earned income is compensation from employment or the actual involvement in a business. This is the most taxed form of income and is the most limited in terms of deductions. Portfolio Income is derived from investments, including: capital gains, interest, dividends, and royalties. Investments held longer than 12 months have preferred tax rates. Losses can offset gains. Passive Income is derived from activities in which you do not actively participate such as: real estate or limited partnerships. Losses have the ability to offset passive income.
Tax deferred income is derived from retirement accounts. Tax deferred income can be converted to tax-free income through the use of a ROTH account. Other strategies exist for adding to the tax-free income category including insurance. Achieving Tax-Free Income is the aspirational goal.
With earned income, deductions are generally available after the income is received. For example, if you’re contributing to a pre-tax retirement account that is based on your income you won’t know how much you can contribute until you’ve received your income.
With portfolio and passive income, taxes are generally mitigated at the time of purchase or sale. For example: you might consider purchasing one of two investments. The investments are alike in all characteristics, purchase price and yield, except one of the investments has an additional offset to income, depreciation. The investment with depreciation is the more tax efficient choice, and it is a choice made at the time of purchase.
With tax-deferred income, the account grows tax-deferred. Since withdrawals are taxed at ordinary income rates, one should consider conversion to a ROTH as early as possible to limit taxation due to account growth. After all, where do you want to be taxed, on the seed, or on the crop?
Review our analysis of clients who have fully deployed their tax mitigation strategies because they have had savings upwards of six figures. One of my core tax beliefs is: Focusing on tax efficiency may significantly enhance portfolio yield. Learn more about investment timing and tax mitigation.
1 IREXA may have investment solutions to help you with your individual tax situations as determined with your CPA or tax advisor.