Key Takeaways
- Four primary tax reduction techniques: income shifting, timing strategies, investment selection, and tax-advantaged accounts
- Income shifting to family members is limited by kiddie tax—unearned income over $2,700 (2025) for children under 19 (or under 24 if full-time student) is taxed at parent's rate
- Timing strategies include deferring income to lower-income years and accelerating/bunching deductions into high-income years
- Tax-loss harvesting offsets capital gains with losses, with up to $3,000 of net losses deductible against ordinary income annually
- Asset location optimizes after-tax returns by placing tax-inefficient investments in tax-advantaged accounts
Tax Reduction Strategies
Effective tax planning requires understanding the four fundamental techniques for reducing tax liability. Each strategy has specific applications, limitations, and timing considerations that financial planners must master for the CFP exam and client service.
The Four Tax Reduction Techniques
| Technique | Strategy | Key Benefit | Primary Limitation |
|---|---|---|---|
| Income Shifting | Move income to lower-bracket taxpayers | Lower marginal rate on income | Kiddie tax, assignment of income doctrine |
| Timing Strategies | Control when income/deductions occur | Match rates to optimal years | Cash vs. accrual limitations |
| Investment Selection | Choose tax-efficient investments | Lower effective rate on returns | May sacrifice optimal allocation |
| Tax-Advantaged Accounts | Use qualified plans, IRAs, HSAs | Deferral or exclusion of income | Contribution limits, eligibility rules |
Income Shifting Strategies
Income shifting involves moving income from a higher-bracket taxpayer to a lower-bracket taxpayer, reducing the overall family tax burden. The primary methods include:
Shifting to Family Members
- Employing family members - Pay reasonable wages to children or spouse for legitimate work performed in a family business
- Gifting income-producing property - Transfer appreciated assets or income-producing investments to lower-bracket family members
- Family limited partnerships - Shift income through partnership distributions
The Kiddie Tax: A Major Limitation
The kiddie tax significantly limits the effectiveness of shifting unearned income to children. For 2025:
| Income Level | Tax Treatment |
|---|---|
| First $1,350 | Covered by child's standard deduction (tax-free) |
| Next $1,350 ($1,351 - $2,700) | Taxed at child's marginal rate |
| Above $2,700 | Taxed at parent's marginal rate |
Who is subject to kiddie tax:
- Children under age 19 at year-end
- Full-time students under age 24 at year-end
- Exception: Children with earned income exceeding half their support are NOT subject to kiddie tax
Exam Tip: The kiddie tax only applies to unearned income (interest, dividends, capital gains). Earned income from wages or self-employment is always taxed at the child's own rate.
Assignment of Income Doctrine
The IRS assignment of income doctrine prevents taxpayers from assigning income they have already earned to someone else. Key principles:
- Income is taxed to the person who earns it (fruit vs. tree analogy)
- You cannot assign wages to a child after you've earned them
- Dividends are taxed to the shareholder of record
- Interest is taxed to the owner of the debt instrument
Timing Strategies
Timing strategies involve controlling when income is recognized or deductions are claimed to minimize taxes across multiple years.
Deferring Income
Postpone receiving income to a future year when your tax bracket may be lower:
- Defer year-end bonuses to the following year
- Installment sales spread gain recognition over multiple years
- Delay exercise of stock options when possible
- Contribute to traditional retirement accounts (immediate deferral)
Best candidates for income deferral:
- Expecting lower income next year (retirement, sabbatical, career change)
- Anticipating lower tax rates in future years
- Building tax-deferred retirement savings
Accelerating Deductions
Claim deductions sooner to offset high-income years:
- Prepay deductible expenses (property taxes, mortgage interest)
- Make charitable contributions in high-income years
- Pay state estimated taxes before year-end
The Bunching Strategy
Bunching (or clustering) concentrates itemized deductions into a single year to exceed the standard deduction threshold:
| Without Bunching | With Bunching |
|---|---|
| Year 1: $14,000 itemized (take standard) | Year 1: $28,000 itemized (itemize) |
| Year 2: $14,000 itemized (take standard) | Year 2: $0 itemized (take standard) |
| Total deductions: $31,500 ($15,750 x 2) | Total deductions: $43,750 ($28,000 + $15,750) |
Bunching candidates:
- Charitable contributions (can be prepaid or use donor-advised funds)
- Property taxes (subject to $10,000 SALT cap)
- Medical expenses (if near 7.5% AGI threshold)
Investment Selection for Tax Efficiency
Tax-Efficient vs. Tax-Inefficient Investments
| Tax-Efficient (Lower Tax Drag) | Tax-Inefficient (Higher Tax Drag) |
|---|---|
| Index funds (low turnover) | Actively managed funds (high turnover) |
| Growth stocks (no dividends) | REITs (ordinary income distributions) |
| Municipal bonds (tax-exempt) | Corporate bonds (taxable interest) |
| Tax-managed funds | High-yield bond funds |
| Long-term capital gains | Short-term capital gains |
Tax-Loss Harvesting
Tax-loss harvesting involves selling investments at a loss to offset capital gains and reduce taxable income:
How it works:
- Sell investment with unrealized loss
- Use loss to offset capital gains (short-term losses first offset short-term gains)
- Excess losses offset up to $3,000 of ordinary income per year
- Remaining losses carry forward indefinitely
Wash Sale Rule: You cannot claim a loss if you purchase substantially identical securities within 30 days before or after the sale. The disallowed loss is added to the basis of the replacement security.
Workarounds for wash sale:
- Wait 31 days to repurchase
- Buy a similar (but not substantially identical) investment immediately
- Harvest losses in taxable accounts; don't apply to IRAs
Asset Location Strategy
Asset location places investments in the most tax-efficient account type:
| Asset Type | Best Location | Reason |
|---|---|---|
| Bonds, REITs | Tax-deferred (Traditional IRA, 401k) | Ordinary income taxed at higher rates |
| High-turnover funds | Tax-deferred | Avoid current tax on gains |
| Tax-exempt bonds | Taxable account | Already tax-exempt; no benefit in tax-deferred |
| Index funds, growth stocks | Taxable account | Low turnover, qualified dividends, LTCG rates |
| Roth accounts | Highest-growth investments | Tax-free growth maximizes benefit |
Tax-Advantaged Accounts Overview
The fourth technique maximizes use of accounts with special tax treatment:
| Account Type | Contribution | Growth | Withdrawal | Best For |
|---|---|---|---|---|
| Traditional IRA/401(k) | Pre-tax deduction | Tax-deferred | Taxable as ordinary income | Current high bracket, expected lower future bracket |
| Roth IRA/401(k) | After-tax (no deduction) | Tax-free | Tax-free (if qualified) | Current low bracket, expected higher future bracket |
| HSA | Pre-tax deduction | Tax-free | Tax-free for medical | Triple tax benefit for medical expenses |
| 529 Plan | After-tax (state deduction varies) | Tax-free | Tax-free for education | Education funding |
CFP Exam Tip: A comprehensive tax plan typically combines all four techniques—shifting income where appropriate, timing income/deductions strategically, selecting tax-efficient investments, and maximizing contributions to tax-advantaged accounts.
In 2025, a 15-year-old dependent child has $4,000 in dividend income and $2,000 in wages from a part-time job. Assuming the standard deduction for dependents, how much of the dividend income is taxed at the parent's marginal rate under the kiddie tax?
A client sells Stock A for a $15,000 loss on December 1 and purchases substantially identical Stock A shares on December 20 of the same year. What are the tax consequences?
Which investment would be MOST appropriately located in a tax-deferred account such as a traditional IRA rather than a taxable brokerage account?