People who develop the skill to earn, invest and create a large net worth still make tax mistakes. From failing to understand tax-loss-harvesting rules to a lack of knowledge about international investing laws, these errors cost rich people both money and time.
Here are five key tax mistakes rich people need to avoid if they want to hold on to their wealth.
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1. Investing Overseas Without Understanding the Tax Consequences
People with high income and substantial net worth often invest internationally. After all, such investments can have a tax-minimizing allure.
But putting money to work outside the U.S. can have risks. Stewart Patton, a U.S. tax attorney and offshore investing expert with Belize City, Belize-based U.S. Tax Services, told one such cautionary tale.
Patton’s client — a wealthy U.S. doctor — fell in love with a tourist spot in Central America. The doctor decided to buy several condos and build an office building. In consultation with both a local attorney and a U.S.-based certified public accountant, the physician was told there would be no U.S. tax implications until the investment dollars came back into the U.S.
Unfortunately, the doctor’s accountant was inexperienced in this area of tax law and did not inform his client about several filing and reporting obligations related to ownership of non-U.S. corporations and non-U.S. bank accounts.
The physician eventually discovered that potential penalties for failing to file these important tax forms might run into six figures. Patton was brought in to assist the distraught doctor.
Fortunately, the doctor’s attorney got his client into an amnesty program and avoided the penalties. But the story highlights the importance of getting experienced guidance when investing internationally, as well as developing an understanding of basic international banking laws.
Fail to do so, and you might rack up penalties in the tens of thousands of dollars.
2. Lack of Awareness About Investing Tax Laws
Wealthy individuals usually hold large investment portfolios. Managing these portfolios with an eye on both growth and minimizing taxes is an important way to retain as much of the capital gains and dividends from these assets as possible.
Henry Goldstone, a certified publish accountant and personal financial specialist, cited several investing tax mistakes that are costly to the wealthy. Most of these mistakes can be minimized with year-round planning and advice from a competent tax attorney.
For example, tax-loss harvesting allows you to sell stocks that have lost value in order to reduce the taxes on the capital gains associated with stock winners. Lack of planning and a failure to use tax-loss harvesting can cost the wealthy thousands of dollars in tax savings.
A hypothetical example illustrates the point. On Jan. 1, 2020, Richard Rich invested $100,000 in an exchange-traded fund (ETF). He bought 1,667 shares at a price of $60 per share. On Jan. 4, 2021, he sold his entire position for $52 per share and received $86,684.
This transaction netted a $13,316 loss. Richard had capital gains on other investments of at least $10,316, so he could offset the loss against the gain and pay zero capital gains taxes on the $10,316 profit. The additional $3,000 loss could be used to reduce his ordinary income.
Saving tax on his $10,316 gain with a tax-loss harvesting strategy saved him $3,817 in potential tax payments because he is in a 37% marginal tax bracket for federal, state and local taxes.
3. Missing the IRA Required Minimum Distribution (RMD)
Some people are rich, retired and have all the money they need. As a result, they might forget that at age 72, they need to take the required minimum distribution from their IRA — whether or not they actually need the money .
Tom Walsh, a certified financial planner with the Palisades Hudson Financial Group has seen people make this mistake, and they have paid dearly.
The law requires you to begin withdrawals from your 401k, IRA, Simple IRA, SEP IRA or other retirement plan account when you reach age 72. This does not apply to a Roth IRA (which does not require withdrawals until after the owner’s death).
There is a formula to determine the minimum amount that must be withdrawn every year, beginning at age 72 and every year thereafter until the account is depleted. If you miss the deadline or do not withdraw enough, you will owe a whopping 50% excise tax on the amount not withdrawn.
The Setting Every Community Up for Retirement Enhancement — aka SECURE Act –which was signed into law on Dec. 20, 2019, states that if your 70th birthday falls on July 1, 2019, or later, you can wait to start taking required withdrawals until you turn 72.
4. Not Using Charitable Giving Opportunities To Lower Taxes
It’s no secret that gifts to charity reduce taxes for the wealthy. Take a look at billionaires Bill Gates, Warren Buffett and Mark Zuckerberg — these three are known to donate huge amounts to charity, and they most likely reap the tax benefits.
Failing to utilize charitable giving tax strategies can deprive high-net-worth taxpayers of large tax benefits, said Scott Thompson, certified specialist in retirement planning and an expert in tax reduction strategies for the wealthy.
You can choose to donate cash, but there are other options that may be more effective in reducing your tax liability. For example, a business owner can donate an office building or other rental property directly to a charitable foundation. With this strategy, the capital gains tax is eliminated. Another such strategy is to donate appreciated stock. If you’ve owned the stock for more than one year and you itemize your deductions on your tax return, you deduct the value of the stock on the day you donate it to the charity. Even if you take the standard deduction, you can avoid the long-term capital gains tax of up to 20% that would occur if you sold the stock first and donated the proceeds to charity.
One more option for people age 70.5 and older is to give up to $100,000 per year tax-free directly from an IRA to charity, which is known as a qualified charitable distribution or QCD. Because the gift is considered as a QCD, it’s not included in adjusted gross income and not taxed.
Note that the terms of the SECURE Act do not apply when making charitable contributions from your IRA. The only restriction is that you must be at least 70.5 years old.
5. Attempting To Avoid Probate and Multiplying the Tax Bill
Mom and Dad are getting on in years when the family lawyer suggests a clever strategy to get their home out of their estate in order to avoid probate. It seems like a brilliant idea — sell the house to Jack and Jill, their children, for $1. Next, change the title to reflect the children’s ownership. That way, the house will never go through probate at the last surviving parent’s death.
However, this is a potentially monumental tax mistake that could cost the children tens of thousands of dollars in tax bills, said Dave Du Val, vice president/chief customer advocacy officer at TaxAudit.com.
There are quite a few reasons to avoid this strategy. Among them is the fact that when the child’s name goes on the deed, she or he is considered to have bought the house at the parent’s price.
Assume that Mom and Dad bought the house 30 years ago for $100,000, and it’s now worth $500,000. If Jack and Jill sell the house and it is not their principal residence, they each owe 50% of the capital gains tax on the $400,000. Jack and Jill now have a $200,000 gain on each of their tax returns in the year the home is sold.
Had they inherited the home at the parent’s death, the home would receive a step-up in basis; in layman’s terms, the house would be inherited at the market value on the sale date. Thus, inheriting the home at a value of $500,000 would result in little or no tax obligation should they sell the house.
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How To Avoid Tax Mistakes as a Wealthy Person
There are scores of tax mistakes that can cost the wealthy thousands of dollars. The best way to avoid these costly tax mistakes is to meet with a competent tax planner who specializes in high-net-worth clients. Also, review your financial situation early in the year, and set up your finances to minimize tax mistakes on your return.
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Cynthia Measom contributed to the reporting for this article.
Last updated: Feb. 19, 2021