The Basics of Building a Tax-Efficient Portfolio

High net worth individuals and small businesses often need help mitigating taxes from:

  1. ordinary income
  2. passive and portfolio income
  3. the purchase and sale of assets including real estate
  4. retirement and estate planning

Tax Planning and Investing Go Hand-in-Hand

First let’s talk about tax mitigation strategies. Tax mitigation is simply the idea of developing investment strategies that reduce your taxes as well as potentially grow your wealth. The choices you make when assets are in motion have tax consequences, and how you manage those consequences can either cost or save you in 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. Each category offers different strategies and vehicles to reduce or defer taxes. 

Earned Income

Earned income is compensation from employment or the actual involvement in a business. This is the most highly taxed form of income and is the most limited in terms of deductions. 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 have received your income.

Portfolio and Passive Income

Portfolio income is derived from investments and includes 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. 

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 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. 

One strategy involves the use of investments that are passive income generators (PIGs). To take advantage of this strategy the client must have additional investable assets, which are used to acquire the PIG. Assets are available with annual returns in the 8% range that provide 85% to 100% passive income. Income generated through the use of this strategy is effectively tax-free until the passive activity losses (PALs) are extinguished. As a result of the recent economic upheaval, some clients have excess passive activity losses. In some cases, the extent of the PAL is such that they cannot be easily extinguished without external intervention. (For related reading, see: 4 Best Passive Income Investments.)

The Purchase and Sale of Assets Including Real Estate

With the purchase and sale of assets, the potential to mitigate taxes can occur at both the time of purchase and the sale. The structure of the acquisition is important. For example, in the world of real estate a very common axiom is “You make your money when you buy.” On the other hand, you minimize your taxes when you sell. In the case of real estate, one can possibly defer all taxable gains to a more opportune time through the use of an IRS § 1031 like-kind exchange. Other asset sales require different strategies. (For more from this author, see: How to Make the Most From Real Estate Investments.)

Retirement Accounts

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 goal.

Each type of income can have tax impacts mitigated by using strategies available in the tax code and by using assets that achieve specific strategic goals.

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?

Tax-deferred income strategies involve structuring a portfolio for tax-efficient retirement plan maximization. Other strategies occur when clients have additional discretionary income that could be more tax-efficiently deployed in a tax-free account.

Required minimum distribution (RMD) deferral program strategies are appropriate for clients who have RMDs but would rather not take them.

  1. The more common strategy involves a qualified longevity annuity contract (QLAC). The QLAC is limited to the lesser of 25% of your retirement account balance or $125,000.00. The use of a QLAC can effectively reduce the size of the retirement account by the amount contained in the QLAC until age 85. As a result, the reduced amount of money in the retirement account reduces the size of the RMD and, consequently, taxes that are owed. This strategy is open to all income levels. (For related reading, see: Longevity Annuity Tax Rules: What You Need to Know.)
  2. The less common but more tax-efficient strategy involves using the RMDs for leverage. In this strategy the RMD is taken and taxes are paid. The after-tax balance is used to fund a life insurance policy to transfer benefits as directed by the insured. Returns can be two to three times higher than with a QLAC. The returns can be tax-free.

Build a Professional Team

Tax-efficient investing and long-term strategies are not built in a vacuum. High net worth individuals should work with financial planners, tax advisors and estate attorneys. Each has a specialty area that involves laws and regulations that are not static. As regulations change, so do the investment vehicles created to build the best investment choices for savvy investors. Each member keeps the others current on investment and tax trends. Together your team knows your personal and dynastic goals, time horizon, risk tolerance, socially conscious imperatives and philanthropic mission. Together they can serve your needs as trusted advisors.

Focusing on tax-efficiency may significantly enhance portfolio yield. The use of some or all of these tax-planning strategies have provided investors with tax relief, often into six figures.1

(For more from this author, see: Create a Tax-Efficiency Team with Tax Professionals.)


Income and net worth restrictions apply.

  1. Except where noted, the client must be an Accredited Investor as defined in Regulation D under the 1933 Act (i.e. $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly two of the last three years).
  2. IRS tax code is subject to change and the IRS could disallow some or all the benefits discussed above. The above numbers are for specific cases. Future performance is not guaranteed.
  3. To effectively utilize all the above strategies tax liability at a federal level should be $90,000.00 or above.

IREXA Financial Services / Wealth Strategies collaborates with CPAs, attorneys, and other tax planning professionals to assist clients with tax mitigation strategies.  IREXA, SANDLAPPER Securities, and Sandlapper Wealth Management are not tax professionals or attorneys. IREXA only provides client tax mitigation strategies through, and with the approval of our client’s professional counsel.

Securities are offered through SANDLAPPER Securities, LLC (SLS), member FINRA/SIPC. Advisory services offered through Sandlapper Wealth Management LLC (SLS-WM) an SEC registered investment advisor, 800 East North St, 2nd Floor, Greenville, SC 29601, 864.679.4701.  IREXA is unaffiliated with SANDLAPPER Securities, LLC and Sandlapper Wealth Management LLC. IREXA and SANDLAPPER Securities, LLC and Sandlapper Wealth Management LLC are not affiliated with Investopedia.