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Advisor Insights

Why Advisors Should Bother With Tax Alpha

A simple way to boost investment performance without adding risk.

When it comes to managing clients’ investments, advisors face more competition than ever—whether it’s from other advisors, broker/dealers, insurance salespeople, robo-advisors, or “do-it-yourselfers.” Advisors can’t promise excess returns over the market’s returns (or at least can’t deliver on that promise on a long-term basis). They can offer additional services such as financial planning and consultations. While these are nice—even important—they do nothing to add to clients’ investment bottom lines.

How can advisors truly add to investment performance without adding risk? By creating “tax alpha.” An advisor can generate tax alpha by incorporating tax-savings strategies into investment management that provide clients both permanent and temporary tax savings. As we’ll see, both can be very valuable to clients.

How to Find Permanent Tax Savings for Clients

Permanent tax savings never have to be paid back to Uncle Sam. Avoiding short-term capital gains is the simplest example of this strategy. Short-term capital gains are incurred on assets held for a year or less. If selling a stock would produce a short-term gain of $10,000, it would cause a high-income taxpayer to pay at least 37% federal tax, or $3,700. If waiting a week would qualify the sale for long-term treatment, the tax rate would be 20%, or $2,000. The $1,700 savings is permanent because it never has to be paid back.

Another tax-savings strategy is location optimization, which has the benefit of providing both permanent and temporary tax savings. Location optimization places an investment in the most appropriate type of account to best minimize taxes.

Most investors have up to three types of investment accounts: taxable, tax-deferred, and nontaxable. Taxable accounts will be subject to current taxation when income is received, in the form of interest (ordinary income) or dividends (typically taxed at capital gains rates), and when assets are sold at a gain (at short-term and long-term rates). Tax-deferred accounts, such as IRAs, annuities, and other retirement accounts, will only incur tax (at ordinary rates) when amounts are withdrawn. Finally, nontaxable accounts, like Roth IRAs, are never subject to tax.

Investments can be also categorized according to their tax characteristics. Some investments throw off continuing ordinary income, such as taxable bonds, while other investments are held primarily for appreciation, with or without dividend streams.

By correctly matching the investment types to the most appropriate types of accounts, investors can save on both current and future taxes.

Typically, investors should hold tax-inefficient investments, such as bonds, in tax-deferred accounts. Their interest won’t incur current taxes, and ordinary tax will only be paid on distribution. This method provides temporary tax savings.

Advisors should put clients’ appreciating investments, such as U.S. stock funds, in taxable accounts. Clients don’t pay tax on appreciation until sold, at which point, gains will be taxed at capital gains rates. (And, if held at death, no tax will be paid.) If appreciating investments are held in an IRA, the tax would eventually be paid at ordinary rates, equating to approximately twice as much tax as capital gains rates. Therefore, this method provides permanent tax savings.

Finally, high-growth investments should be held in the Roth IRA to get the biggest benefit from the tax-free account. Because Roth IRAs are typically the last account to be tapped for distributions, they can ride out the short-term ups and downs of aggressive investments.

To summarize the strategy:

  • Hold tax-inefficient investments in the IRA to defer tax until distribution (temporary tax benefit).
  • Hold appreciating assets in taxable accounts to defer tax on appreciation, and only pay capital gains tax when sold (permanent tax benefit).
  • Hold high-growth investments in Roth IRAs to get the maximum benefit from nontaxable status (permanent tax benefit).

What Are Some Temporary Tax-Savings Strategies?

Temporary tax savings merely postpone tax. One strategy is harvesting tax losses. For example, let’s say an investor owns a large-cap index fund worth $5,000 with a tax basis of $8,000. By selling the fund and replacing it with a similar (but not “substantially identical,” as required by the IRS) large-cap fund, the investor gets to recognize a $3,000 tax loss. However, the new shares now have a cost basis of $5,000. Selling the shares later when the value becomes $9,000 would result in a $4,000 gain, which is $3,000 more than if the original shares were held until this sale. Thus, temporary tax savings will typically need to be paid back to the government.

Temporary tax savings should not be ignored merely because there could be a price to be paid later. Even if the investor must eventually pay the tax savings, there is a benefit from compounding and the time value of money.

Sometimes, however, the tax savings do not need to be paid back. Current tax laws allow a basis step-up for securities held at death. So, if the holdings are not sold at a gain during the lifetime of the investor, the temporary savings become permanent savings at death. Although this savings method doesn’t help the deceased investor, it is valuable to heirs. Another option is that the investor could donate the appreciated shares. The investor gets a deduction at fair market value, and the gain is never recognized.

Other temporary tax-savings strategies include choosing high-cost lots and avoiding capital gains distributions.

Choosing high-cost lots means either identifying specific lots of assets when selling or choosing the custodian’s “high cost” (while avoiding short-term gains) or “best tax” identification option. For example, an investor wants to sell 300 shares of ABC Co. at $250. The investor owns one long-term lot of 400 shares at a cost basis of $200 a share and another long-term lot of 600 shares at a cost of $240 a share. Selling 300 of the $240-share lot will result in $3,000 of gain. Selling the shares at the total lots’ average cost of $224 a share will result in $7,800 of gain. Although later sales would require recognizing the deferred gain, the present value benefit can be substantial.

Similarly, avoiding year-end capital gains distributions can produce temporary tax savings. Toward the end of each year, mutual funds distribute internally recognized capital gains to shareholders. This phantom income must be reported on the shareholders’ tax returns even though they received no cash. Capital gains distributions are not a pleasant surprise to clients. To avoid this income, advisors must sell out of the fund before the phantom dividends are posted. This means identifying a replacement fund with no or smaller distributions and taking into consideration whether the sale will result in a gain or loss. Since this process can be quite complex, most advisors will apply this strategy only if they have software to do it.

When implementing temporary tax-savings strategies, it is especially important to note economic cost versus the amount of temporary savings. For example, if tax-loss harvesting can produce a temporary tax benefit of $500, but there is no viable replacement fund, it’s probably better to pass on the transaction. In other words, don’t let temporary tax savings negatively affect a client’s long-term investment strategy. (For a permanent savings, it might be worth it to deviate from the investment strategy.)

3 Ways to Implement Tax-Alpha Strategies

There are basically three ways to implement tax-savings strategies: manually, automatically, or delegating.

Using manual techniques is the most difficult. It’s time-consuming and will miss tax-savings opportunities. True, manual portfolio management can be streamlined to some degree, but it’s a challenge. The advisor must choose the custodian’s high-cost or best-tax-basis method, rebalance at least quarterly, harvest material losses during the year, avoid material capital gains distributions, and ensure that bonds are placed in IRAs while high-risk investments are in Roth IRAs.

Sophisticated rebalancing software, on the other hand, can do it all. For example, Morningstar Total Rebalance Expert—software that I developed and sold to Morningstar—can automate all of these strategies based on parameters set by the advisor and client. This means no material tax-loss opportunities will slip by; investments will be automatically placed in correct accounts; short-term gains will be avoided; high-cost lots will be chosen for sales; and capital gains distributions can be avoided when there are material savings. Easy to implement and reasonably priced, Total Rebalance Expert can give advisors an edge when it comes to providing tax alpha to clients.

Delegating portfolio management to a turnkey asset-management program or a direct-indexing provider also can take on most of the burden of tax management. Pricing and specific offerings differ by providers. (Morningstar provides both services. More information can be found here and here.)

Tell Your Clients How Much You’re Saving Them!

Whatever method advisors choose, they must tell their clients what benefits they are providing. Much of the tax-alpha work is behind the scenes. It’s up to advisors to educate their clients on how much tax money they’re saving them.

Advisors should repeatedly explain location optimization to clients—in webinars, seminars, emails, meetings, and reports. It is only through ongoing education that a client can begin to understand the benefits of holding certain types of investments in different accounts—whether it’s their IRA, Roth IRA, or taxable account.

Advisors should also quantify the tax savings their strategies are providing clients. There are two ways to communicate this to clients: through automated reports and by tax-return analysis. Total Rebalance Expert, for example, can produce individualized client-savings reports, showing savings from tax-loss harvesting, selling high-cost lots, avoiding capital gains distributions, and locating fixed income in IRAs. Enclosing these reports with quarterly reports can be hugely impactful to clients.

After clients have their tax returns prepared, advisors can calculate the tax clients paid on investments. They then can compare this amount of tax to the total income plus appreciation on their portfolio. For example, let’s say a client has a $2 million portfolio that received interest of $10,000, qualified dividends of $60,000, and appreciation of $70,000. The tax return reported no interest (because it was earned in the IRA), dividends of $60,000, and no gains (gains were offset by harvested tax losses). The client paid tax of $12,000 ($60,000 times 20%) on income and growth of $140,000—less than 10% of that amount, or 0.6% of account’s total value. This type of analysis really gets the message across.

For Advisors, Tax Alpha Pays for Itself

Investing has become commoditized. If advisors want to keep their clients and increase their assets under management, they need to differentiate themselves. Although I believe financial planning is necessary to truly be a financial advisor, creating tax alpha is key to adding real value to clients.

The views expressed in this article do not necessarily reflect the views of Morningstar.