Tax Strategies to Maximize Your Retirement Savings
HOW TO LOWER YOUR TAXES
by Steven Casto
Lower Your Tax
Many taxpayers think that the capital gains rate was cut to 15%
in the last round of tax cuts. That’s right, but it’s
only part of the story. Many investors qualify for an even lower
5% capital gains rate. How do you get this lower rate?
The 5% capital gains rate applies to taxpayers who are in the
15% marginal tax bracket (e.g. married couples and singles with
taxable incomes below $56,800 and $28,400, respectively). While
some taxpayers are consistently above these levels, they should
not overlook a chance to lower their tax bracket for one year in
order to take advantage of a lower capital gains rate.
For example, some people live comfortably on pension and Social
Security income. They have been in the 28% federal tax bracket
for many years. Because of some recent purchase of property and
new mortgage deductions, their tax bracket has dropped to 15%,
temporarily. While the 15% regular tax bracket applies to them,
they can sell some appreciated assets and enjoy the 5% capital
Let’s say a retired couple has $60,000 of income, but they
have heavy deductions that year, reducing their taxable income
to $30,000. (Other ways to reduce taxable income include using
a short-term annuity or tax-free bonds.) Since the 15% tax bracket
extends up to $56,800 for married tax payers, filing jointly, they
could use up to $26,800 ($56,800 minus $30,000) of capital gains
and have them taxed at 5%. Another way
to enjoy the 5% capital gains rate involves gifting stock or mutual
funds to a grandchild (who is in the 15% tax bracket), and having
the capital gains upon sale taxed at only 5% to him or her.
This may be an opportunity for you to cut your capital gains tax
by two-thirds from 15% to 5%, but remember, you need to time the
sale of your securities correctly.
Tax Loss Planning
Every year, thousands of investors in stocks and mutual funds
miss the benefit of tax loss selling—when an investor has
the government share his or her investment losses by reducing his
or her taxes.
If you bought a stock at 20 and it’s now 15, even if you
plan to hold it for the long term, sell it now! By selling, you
can report a $5.00 loss per share on your tax return. Take a deduction
(or offset other stock gains) and reduce your tax bill or receive
a refund. You can then buy the shares back in 31 days and keep
them as long as you like.
If you just sit there with your paper loss and December 31 passes,
the government will not share the loss with you. You must actually
make a sale to capture the tax benefit. If you miss this each year,
you throw away a tax savings and pay more taxes than necessary.
Make it a ritual to sell your losers each December and have the
IRS share the loss with you.
A woman recently came to see me about converting her annuity to
a life insurance policy. Her husband had died four-and-a-half years
ago and the annuity had been left to accumulate. Unfortunately,
the agent had written the annuity so that the children were the
beneficiaries. The wife had no claim to this money! Moreover, the
entire interest in the annuity ($280,000) must be distributed within
five years of the owner ’s death (IRC section (72) (s)(1)).
Therefore, since the end of the five years was near, the entire
annuity soon had to be distributed to the children and the tax
bill would exceed $50,000!
Had the original agent understood what he was doing, he would
have made the wife the beneficiary or the husband and wife joint
owners or joint annuitants. This lack of knowledge is causing this
family a large premature tax bill. Here’s the point: please
obtain annuities from someone who understands the tax ramifications.
Has your annuity been written correctly?
Yearly Tax Review
Although you’d like your accountant to give you tax tips,
many do not. They simply prepare your tax return and let you go
to accumulate another tax bill for the next year. If you seriously
want to cut your income taxes, go see your accountant or financial
advisor before December 31. Here are the kinds of savings you can
- Mutual funds, which are generating too much short-term gains
(taxed at higher rates) rather than long-term gains.
- Higher than necessary IRA distributions.
- Unnecessary payment of taxes on Social Security income.
- Opportunities to increase current income.
- Opportunities to sell securities and avoid capital gains.
- Opportunities to remove money from IRAs or pension plans at
substantially reduced taxes.
- Improper investment of bypass trust assets, where one spouse
If you are tired of paying more tax than necessary and want to
do something about it, you can stop the waste. Don’t think
that your accountant has given you the answers unless you ask!
For years, the wealthy have been using estate planning techniques
that may be unfamiliar to many people who could benefit from the
same techniques. For example, if estate taxes are a concern, read
how you can use a simple device, the “Family Partnership,” to
slice your tax bill.
Let’s say that you and your spouse own a farm with a $1
million value. If it is left in your estate, this property could
be burdened with estate taxes up to 48% of the value. Wouldn’t
it be nice if you could “shrink” the value for estate
tax purposes? The family partnership can do that for you.
All you have to do is ask an attorney to draw up a family partnership
document, which creates a family partnership (just like you had
the attorney draw up a living trust document, which created a living
trust). The farm now gets deeded to the family partnership. This
is a non-taxable event. (Per the IRS, a transfer to partnership
in return for partnership interest is not taxable.) In return for
donating the farm to your family partnership, you and your spouse
receive 100 partnership “units” in return as evidence
of your ownership in the partnership. Think of these units as shares.
Each year, you begin gifting some of these partnership units to
your children. You might think that each unit is worth $10,000
($1 million divided by 100 units). But here’s the best part.
For estate tax purposes, the farm inside the family partnership
is worth less— let’s say $700,000 in this example,
and each partnership unit is worth (for tax purposes) only $7,000
in the hands of your children. (The actual discounted value is
ascertained by an appraiser who is experienced in setting discounts
for family partnership assets.) Why is there a discount?
The IRS allows a valuation discount for two reasons. The first
is “lack of marketability.” The IRS agrees that the
units you gift to your children are virtually unsellable to anyone.
Secondly, your children have no control over the farm. This is
called the “minority interest” discount. As a result,
the farm value for estate tax purposes is now only $700,000! You
have just wiped out $300,000 of estate value (a potential estate
tax savings of $144,000) by forming a family partnership.
But the partnership has other benefits. Let’s say someone
falls off a ladder working on your house and sues you. Your assets
in the partnership are protected from suits and creditors. (Claimants
only have “charging orders” in states that have adopted
the uniform act.) Even though the partnership units may be gifted
away over time to your children (to remove the value from your
estate), you can remain the lifetime general partner. That means
you are always the boss. You decide how the farm gets managed,
whether to sell it or borrow against it or whatever decisions you
choose to make. It’s all in your control.
For a combination of estate tax savings, protection from creditors
and ease of estate distribution, a family partnership can be a
very powerful tool.
What is a Gift Annuity?
Periodically, someone who sold some stock or property earlier
in the year wants to know what he or she can do to offset the large
tax bill created by the sale. While planning before the sale provides
a lot more options, there is still a way to save tax after the
sale with a gift annuity.
A gift annuity results by making a gift to a qualified charity,
but you get income from the gift for life and you get an immediate
tax deduction that can be used to shelter the tax from your real
estate or stock sale. Let’s look at an example. 58
Suppose Mr. Jones, age 70, sells a property for $100,000 that
has been fully depreciated. Let’s simplify and assume a tax
due of $15,000. Can he shelter this tax? Yes.
He can set up a gift annuity. He contributes the $100,000 of his
proceeds and receives a $6,500 annual income for life (of which
59% is considered a tax-free return of principal and not taxed
until the gift is recovered). In addition, he receives a tax deduction
of $38,660 right away. Look what he has accomplished:
- He has offset part of his capital gains tax with a tax deduction
- He generates a lifetime income of $6,500 annually, partially
- He benefits his favorite charity
It gets even better if Mr. Jones does not need the income today.
He can defer it. If he defers the income for ten years, his income
will increase to $ 14,647 per year and the tax deduction increases
The same technique can be used to shelter taxes from an IRA or
retirement plan distribution, while still providing an annual income.
Since the annual income from a gift annuity is based on age, the
older the contributor, the larger the income.
If interested, a qualified advisor can provide a quotation of
income and tax savings for your situation.
Sell Real Estate and Avoid the Tax
Do you have a single –family rental property that was purchased
years ago with big gains? It may not be convenient, but if you
and your spouse move in and live there for two years, you can then
sell and avoid tax on the first $500,000 of gain ($250,000 for
a single taxpayer). In fact, you could unload a whole portfolio
of rental houses, and possibly do so tax free, by living in each
for two years before selling.
Do you own an apartment building that you no longer want to care
for and want to go live in France for a year? You can exchange
the apartment building for any other investment property, such
as ownership of say, a McDonald’s location (a hypothetical
example to illustrate the concept). Under a triple net lease, McDonald’s
(or the franchisee) take total responsibility for the property.
Your monthly rent check can be deposited in your bank account as
you travel through the Bordeaux region. (Note: when you exchange
real estate, you do actually exchange one property for another.
You sell your property and those funds go immediately into escrow
for the new property you are purchasing. Such an exchange is tax-free).
Maybe it’s time to get rid of those 500 acres of farm land
that doesn’t make any money. You can donate it to a charitable
trust, and as the trustee, sell it tax-free. Then you can invest
the money as you see fit in stocks or bonds, receive a hypothetical
8% payout (or a rate you select based on IRS limits), lifetime
annual income from the property out of your hair and out of your
estate (and at the same time create a nice donation for your favorite
charities when you pass on and a nice tax deduction for yourself).
The tax rules provide flexibility when it comes to real estate.
It’s easy to harvest profits and avoid taxes in many situations.
Mutual Fund Turnover Costs
Many investors own mutual funds, but few of them realize how much
they really earn after taxes. Here’s a little insight from Creating
Equity by John Bowen. In a study commissioned by Charles Schwab
and conducted by John B. Shoven, professor of Economics at Stanford
University, and Joel M. Dickson, a Stanford Ph.D. candidate, taxable
distributions were found to have an impact on the rates of return
of many well-known retail equity mutual funds.
The study measured the performance of 62 equity funds for the
30-year period from 1963 through the end of 1992. It found that
the high-tax investor who reinvested only after-tax distributions
would end up with accumulated wealth per dollar invested equal
to less than half (45%) of the funds’ published performances.
An investor in the middle-tax bracket would see only 55% of the
performance published by the funds.
Another study, by Robert H. Jeffrey and Robert D. Arnott, published
in the Journal of Portfolio Management, concluded that
extremely low portfolio turnover can be a factor in improving a
fund’s potential after-tax performance. Asset class funds
typically have very low portfolio turnover, which translates into
less frequent trading and, therefore, may result in lower capital
gains. Low turnover also may benefit shareholders by holding down
In plain English, the above studies indicate that you can lose
a lot of your returns from mutual funds to taxes and that funds
with high turnover tend to generate higher taxes for you. You can
find out how tax-efficient your funds are by consulting information
services available in many local libraries or consulting a financial
advisor experienced in the tax issues of mutual funds.
Lower Your Capital Gains Taxes
There are at least four ways to eliminate or defer capital gains
tax upon the sale of an asset. These ideas are outlined for you
- Before the sale, donate the asset to a charitable remainder
trust and have the trust sell it and then provide the income
- Donate the appreciated asset to a personal foundation and have
the foundation employ you or your family members (in addition
to doing good works in the community). Take a tax deduction for
- In the case of stock, you can exchange shares of stock for
an interest in a specialized small business investment company
(SSBIC)—essentially a mutual fund of small company stocks.
Thus, you can diversify what may be too much money in one stock
for an interest in several, and thereby reduce your risk. If
these new shares are held until death, no capital gains tax is
- In the case of real estate, an unwanted old apartment building
can be exchanged for a chain location on a triple-net lease (e.g.
McDonald’s). You eliminate all management headaches, as
the chain has full responsibility for the property. You get a
nice rental income check each month and if the property is held
until death, there is no capital gains tax.
Want a Significant Tax Deduction?
If you would like to generate a significant tax deduction, consider
giving away your house, but don’t move out!
Many charities will work an agreement with you to take your house
as a bequest when you pass away, and yet provide you with the charitable
deduction this year. You continue to live in your house for your
lifetime, yet have the benefit of saving tax dollars this year
(and possibly into future years). So if you have been thinking
about a significant charitable contribution, this may be a painless
alternative for making a contribution to your favorite charity.
If you leave your house through your will or trust, you get no
income tax savings. If you make the arrangements now, then you
could save tens of thousands of income tax dollars. That’s
money you can spend now.
You can achieve some of the estate tax benefits and leave the
house to your heirs, at a discounted estate value, by using the
Qualified Personal Resident Trust (QPRT). This type of trust splits
the value of your residence into two parts—the value represented
by the time you will live in the house during your lifetime and
the “remainder” value that you leave to your heirs.
The present value of this remainder interest can be a heavily discounted
figure for estate tax purposes. The smaller your estate is calculated
to be, the lower the estate tax. Consult a legal advisor for more
information about this option.
How to Lower Your Social Security Taxes
As retirees well know, the federal government takes back part
of your Social Security through taxes. Depending on your level
of income, the tax can be levied on up to 85% of your Social Security
benefits. Can you beat the tax? Yes, many can and here’s
The general approach is to defer income. Deferred income does
not appear on your tax return, it is not part of your taxable income.
Therefore, deferred income can reduce the amount included for the
Social Security benefit tax calculation. 62 Tax-free income will
not reduce the tax on your Social Security income, because tax-free
income is included in the IRS Social Security tax calculation.
Here are your sources of tax-deferred income:
Deferred Annuities: Some investors shy away from
annuities, because they have the mistaken impression that all annuities
tie up their money. In fact, annuities are issued in terms as short
as one year. Reinvested interest is all deferred and such an investment
can reduce or eliminate the tax on Social Security income.
Certain Zero Coupon Bonds: There are a few issues
of corporate zero coupon bonds that have tax-deferred status. (Even
though E-bonds are tax-deferred, the IRS specifically includes
them when calculating the taxes on your Social Security income.)
Can a Trust Help with Taxes?
There are as many kinds of trusts as there are flavors of ice
cream. Many can help save taxes. Here are a few ideas:
Personal Residence Trust: Think of your house
as having two portions of value—the time you spend living
in your home for the rest of your life and the value of the home
after you die that you leave to your heirs (the residual value).
It’s the second portion that is part of your estate and potentially
subject to estate taxes. The IRS allows you to give that portion
to your heirs now at a discounted value to potentially save estate
If you are familiar with the concept of “present value,” you
know that one dollar, 20 years from now, is only worth 45 cents
today (discounted at 4%). Therefore, you can place that discounted
residual value in a trust now and remove it from your estate. If
you are alive at the end of the trust term, you will need to pay
your heirs rent to live in your house because technically, you
will no longer have any right to ownership or right to reside there.
If the trust outlives you, you have potentially saved a fortune
in estate tax.
Grantor-Retained Income Trust: This type of trust
works similar to the above except that rather than placing your
house in a trust, you place other assets—stocks, funds, investment
property. Again, you remove the future value of the asset from
your estate today.
Private Annuity Trust: This works for passing
real estate to heirs and deferring capital gains tax. For example,
you could make an apartment building that you own and place it
in the trust in exchange for a note. The trust sells the building
(and owes no capital gains because the basis and the sales price
are the same). The trust invests the money and makes payments to
you on the note. You pay capital gains tax as you receive each
payment and spread the taxes over years.
At your passing, the note is extinguished and the assets in the
trust pass to your heirs, estate tax free.
These are just three ideas using trusts that can keep the IRS
away, increase your financial security (assets in trust are usually
protected from your creditors) and increase benefits to family.
Excerpted from Is Your Retirement Heading in the Right
Direction? by Steven Casto. Copyright © 2005 by NFC
and Steven Casto. All rights reserved. Excerpted by arrangement
with Steven CSasto. $19.95. Available in local bookstores or