When it comes to optimizing a client’s investment portfolio through tax-aware best practices, most tax professionals are hesitant to get involved, as we detailed in our Sept. 10, 2015, Tax Insider article. Yet, without a tax practitioner’s ongoing planning and involvement, the benefits of tax-aware management are less likely to be achieved.
The problem: Taxes, self-interest, and complexity
Portfolios held by private individual clients involve taxable and tax-deferred accounts. The key difference between these accounts—tax treatment—makes portfolio planning far more challenging. Tax-aware investment management means actively attempting to maximize the after-tax return an investor receives. The goal of investment management for high-net-worth investors should always be to actively postpone the realization of taxable gains, especially short-term gains, while maximizing realized losses when available. Resolving the problems identified above and achieving the best possible after-tax return outcome for each client requires adopting portfolio planning best practices.
The solution: Portfolio planning best practices
A core-satellite approach
Core-satellite is an established method of portfolio construction that can offer investors the potential for improved performance, especially on an after-tax basis. In core strategies, where little is to be gained from high turnover, less active, low-turnover management is employed along with dedicated tax planning across the portfolio. The goal of this approach is thoughtful tax planning based on specific client objectives involving location management, ongoing tax-loss harvesting, holding period management, and proper tax-lot accounting. Further, through the use of separately managed accounts, clients have complete transparency into the investment management process, including trade confirmations and custodial and transaction fees. Greater transparency supports lower costs, improved investor understanding, and better investment returns over extended time frames.
In satellite strategies, where an active manager has established the ability to outperform the market, exchange-traded funds (ETFs) and/or active mutual funds that offer unique exposure to both risks and gains are also used. Satellite strategies are often tactical or temporary in nature and include specialty fixed-income, specialty equity, real assets, real estate, and alternative investments.
Advisers often construct highly complex portfolios that blur the lines between core and satellite. These portfolios may have overlapping mutual fund and ETF exposures that can be difficult to identify. Management of this kind often leads to higher turnover of investments, little or no tax planning, unintended market risks, and thus mediocre returns. As discussed in our previous article, the use of separately managed accounts within core portfolios can overcome these problems.
Knowledge of each client’s unique situation
Successful tax-aware management requires specific knowledge of each client’s overall tax status, restrictions on securities the client can invest in, holdings of long-held, low-basis stock, cash flow needs, and other relevant factors. Communication and cooperation among tax, estate, and investment professionals insure that this knowledge can be used to support the best possible outcome.
Proper handling of withdrawals and contributions to these investment accounts should support a better planned gain realization outcome as well. Establishing an annual budget of how much gain will be taken in a year and the tax-lot accounting method (typically, highest in first out, or HIFO), in line with the client’s objectives, should help to avoid unnecessary year-end tax surprises while optimizing after-tax returns. Once a practitioner acquires this information, it should result in better asset location management.
Asset location management
As explained more fully in our September article, asset location management involves determining the proper placement of client assets across taxable and tax-deferred accounts. The first exhibit below illustrates a portfolio in which each account is identical to the others and thus poorly designed from a tax perspective.
Exhibit 1: Many investment advisers intentionally duplicate asset location across all client accounts.
This treatment damages after-tax returns and, in an age of higher taxes, can be highly counterproductive.
Thoughtfully assigning assets a specific account location based on the tax implications for a client is often the most valuable service an investment adviser can provide. In addition, this planning can benefit from the support of a knowledgeable and dedicated tax professional. The second exhibit demonstrates the best practices in choosing where to locate assets. Each investment is assigned a specific account based upon its unique tax consequences. In this example of a more appropriate asset location, there is no one-size-fits-all portfolio, and scaling to achieve cost savings in managing the accounts is not the objective.
A well-designed location management solution should:
- Plan taxable portfolios with an eye toward limiting or postponing gains wherever possible;
- Use retirement deferral accounts for short-term or tax-inefficient portfolio investments; and
- Maximize tax-aware best practices to improve after-tax performance with little or no adverse effect on pretax returns.
Exhibit 2: Investments are assigned tax-aware locations.
This asset location management example is provided for illustrative purposes only. The strategies presented were designed to address a specific case and should not be considered recommendations. Best practices will vary by client risk tolerance, stage of life, and other circumstances.
Location management benefits
The second exhibit could illustrate the best asset allocations for a hypothetical couple with a large nest egg who are about eight years from retirement. Conservative growth (attained through an allocation of 60% in stocks) is currently their objective, but income will become a priority when they retire. The size of this portfolio, over $1.5 million, allows for two separately managed accounts (SMAs). Unlike the first exhibit, investments are assigned tax-aware locations.
The largest account in the two portfolios is the “core” portfolio, which contains 30% of the total assets and is held in a taxable account. This account consists of a high-quality, actively managed, low-turnover SMA of large cap stocks, which acts as a long-term counterbalance to activities elsewhere in the portfolio—particularly the realization of gains. Realized losses are maximized in line with the annual gain/loss budget, while gains, especially short-term, are postponed.
The other high-quality, blue-chip stock SMA (15%) is invested in securities with a dividend growth objective. This account is held in a deferral account to avoid the realization of ordinary income associated with dividend payments and capital gains. The 10% allocated to international developed country equity is invested in a highly diversified, developed-market ETF. Although this investment is held in a taxable account, it is a long-term positon designed to grow untouched so that gains may be postponed indefinitely (until sale).
The short-term, fixed-income, and near-cash holdings are held in a taxable account and invested in both a municipal money market fund and a short-maturity municipal bond fund to avoid taxation on income from those investments. The longer-term, fixed-income allocation of 20% resides in a tax-deferred account and is invested in a series of highly rated corporate bonds with laddered maturities from two to 10 years. These bonds are in a tax-deferred account to avoid taxation of the income.
Alternative investments and real assets, which include investments such as real estate, real estate investment trusts, and master limited partnerships, add diversification and unique sources of return as satellite holdings. These investments often exhibit higher levels of turnover and are therefore held in deferral accounts to avoid short-term gains, which are taxed the same as ordinary income.
While quantifying the various benefits attributable to tax-aware planning is difficult and will vary by family circumstances and stage of life, two recent research papers indicate that location management best practices can add from 50 to 75 basis points of value to clients’ portfolio returns (see our September article for more). We also emphasize planning withdrawals from the different accounts in the most cost-effective way, which also includes tax planning. We believe that investment advisers being involved in this planning will add value to clients’ portfolios.
Improved client outcomes should always be the focus of trusted advisers. Successfully resolving these issues will not just happen, but it will require dedicated planning by committed professionals. Providing transparent and measureable performance results along with the previously described best planning practices is difficult for even the best advisers. Clearly, without having, employing, and engaging a committed tax adviser, the benefits of tax-aware management planning are unlikely to be achieved.
We would like to recognize our colleague and great friend, Doug Rogers, for his groundbreaking work in the area of tax-aware investment management. Sadly, Doug passed away this past February.
Steve Riley, CFA, CFP, and Rick Furmanski, CFA, CFP, are tax-aware portfolio managers at Clearview Wealth Solutions in Lake Zurich, Ill.
AICPA Resources
The AICPA Personal Financial Planning Section offers a free guide, The CPA’s Guide to Investment Advisory Business Models, to determine if you have crossed the line when providing investment advice to your clients and are subject to additional regulatory requirements. This guide outlines those regulatory requirements, standards of professional conduct, business models available to your firm in providing personal financial services, and resources available to you as you start or grow a PFP practice.
