When it comes to optimizing a client’s investment portfolio through tax-aware investment best practices, most tax professionals are hesitant to get involved. Whether because of a lack of time or the reluctance to challenge the investment adviser’s autonomy, tax professionals are unwilling to insert themselves into the process. Yet, without a tax professional’s being actively involved in planning, the benefits of tax-aware management are unlikely to be achieved.
For most investment advisers, tax-aware management is a challenge. Not only does it limit their control over the management of the assets, but it may also restrict their capacity to scale their operations by treating all portfolios similarly. Many advisers are not savvy about tax-aware practices. In fact, many do not offer separately managed accounts (SMAs), which are required to reap the full benefits of tax-aware management. SMAs ought to be used whenever possible because they allow each security to be treated independently in the most tax-aware manner for the client. SMAs involve investors receiving statements that list the investment in each security separately, unlike a mutual fund, where the fund value is reported as a whole.
Tax-aware investment management is defined as actively maximizing the after-tax return an investor receives. The goal of investment management for high-net-worth clients should always be to actively postpone the realization of taxable gains, especially short-term gains, while maximizing realized losses.
Tax-aware investment management is not the same as tax-efficient management because that strategy may prevent investors from taking advantage of new opportunities since holdings (such as exchange-traded funds (ETFs), which lack embedded gains at purchase) are held passively to postpone the realization of gains or losses indefinitely. Most importantly, a tax-aware strategy should be undertaken without adversely affecting the client’s portfolio performance. Achieving this goal should maximize investor wealth based upon the time value of money—the most basic objective of modern finance.
Planning: Thoughtful Asset Location Management
While it is uncommon for investors to outperform the stock market by actively selecting stocks, thoughtful, disciplined allocation management and investment planning have been proved to add measurable returns to investors. Many investment advisers handle all of their client accounts—deferred or taxable—alike regardless of the tax implications (especially on realized gains). In an age of higher and higher taxes, this is can be highly counterproductive. Thoughtfully assigning assets a specific account based upon the tax implications for each client is one of the more important and valuable considerations an investment adviser can provide.
Well-designed portfolios that make use of SMAs (and individual securities) provide the greatest flexibility to respond to unique client objectives. And as the client’s investment priorities change, the proactive adviser can judge each position independently as to whether it achieves this new purpose. With careful planning, both transaction costs and realized losses/gains can be skillfully controlled while highly appreciated tax lots can be gifted to charity. In recent years, more investment managers have become willing to support this more client-centered form of asset management.
|Gain an in-depth understanding of each client’s tax profile.|
|Use separately managed accounts for client customization and ease of tax management.|
|Communicate with investment and estate counsel to determine best asset locations.|
|Plan taxable portfolios to limit or postpone gains wherever possible.|
Use deferral accounts for short-term or tax-inefficient portfolio investments.
|Practices to Avoid|
|Allowing taxes alone to drive important investment decisions.|
|Forcing accounts to fit an adviser’s “model” for the sake of investment simplicity and scale.|
|Creating complex investment portfolios with many overlapping mutual funds and ETF exposures.|
Analyzing investment returns only on a pretax basis (especially active trading programs).
Execution: Disciplined Realization of Both Gains and Losses
Once the proper planning is in place, the portfolios can be funded. Securities that fall below their original purchase price can be sold as a way of creating realized losses (often referred to as harvesting a loss). These losses can be used to offset gains realized elsewhere in the portfolio in current or future years (though long-term losses cannot offset short-term gains). With most investment managers, loss harvesting is offered only once near the end of the year. However, actively harvesting losses throughout the year, as opportunities occur, can be a great way to add value to the portfolio on an after-tax basis.
Through proactive investment management and meticulous security selection by the investment manager, the sale of appreciated securities may be delayed and thus capital gains deferred for an extended period. Engaged advisers typically use “highest in, first out” (HIFO) tax-lot accounting to minimize the near-term tax impact on sales and thus improve after-tax returns. Proper tax-lot planning and execution along with budgeting of allowable net gains completes the process.
When a security is sold and then repurchased within 30 days of its sale, the realized loss cannot be used to shelter gains because of the Sec. 1091 wash-sale rules, which can be difficult to avoid when the investment adviser employs several separate account managers holding the same securities. For this reason it is important to use fewer managers, each with a different investment objective, across the entire portfolio.
|Maintain accurate tax-lot accounting and use HIFO accounting to minimize taxes.|
|Consider taxes in the timing of transaction decisions.|
|Harvest losses on an ongoing basis with a focus on positions held less than one year.|
|Take gains sparingly with an emphasis on positions held for more than one year.|
|Establish an annual gain budget for each client—encourage investment counsel support.|
Avoid wash sales through thoughtful planning and execution.
|Practices to Avoid|
|Wholesale or excessive liquidation of portfolios.|
|Waiting until late in the year to loss harvest for the convenience of the investment manager.|
|Selling a security or fund and remaining in cash throughout the wash-sale period.|
|Not planning for or anticipating alternative minimum taxes (AMT).|
Purchasing a replacement fund with identical holdings during the wash-sale period.
In 2014, research by Vanguard indicated that an adviser could add up to 3% to a client’s annual portfolio return through factors such as lowering costs, rebalancing, behavioral coaching, and asset location (i.e., the allocation of funds between taxable and deferred tax accounts) management (Kinniry, et al., “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha” (Vanguard, March 2014)).
Similarly, Morningstar claims that clients at or near retirement could improve investment performance by as much as 1.6% through what it calls “Gamma” (Blanchett and Kaplan, “Alpha, Beta, and Now . . . Gamma,” (Morningstar Investment Mgmt., Aug. 28, 2013)). Gamma is defined as the potential value added by an adviser through thoughtful financial planning decisions, including optimizing asset allocation, dynamic withdrawal strategies in retirement, use of guaranteed income products, tax-efficient decisions, and liability-relative asset allocation (meaning assets are chosen with awareness of risks such as inflation and currency fluctuation).
While quantifying the various benefits of tax-aware planning and execution is difficult and will vary by family, the research papers cited above indicate that tax-aware best practices may enable both tax professionals and investment advisers to provide added value to their clients. Tax professionals should step into the process and work with the investment adviser to create a more optimal result for their clients. Clearly, without an engaged tax practitioner’s committed planning and involvement, the benefits of tax-aware management 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, he 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.