Assessing the impact of taxation on your client’s wealth
Fiduciaries often focus on the risk/return relationships of assets and portfolios. This makes sense, but fiduciaries must also offer a careful review of the probable tax impact of any investment strategy — without a tax-efficient focus, their work remains incomplete.
When investing others’ money, consider the client’s overall end wealth. Taxes affect how growth compounds over time. They can even wipe out extra returns gained by making active investing decisions. If you manage clients’ money, keep in mind the various angles of tax efficiency. You can also consider using an outside professional to help you pursue tax management goals.
A pension fund doesn’t pay taxes on gains, but private clients often have more than one account type — with higher or lower balances in each. And each account might require special tax treatment.
Thoroughly understand the position of your client so you can take the greatest advantage of the current tax code.
A good starting point for analyzing a client’s tax situation includes at least the following:
Tax planning can be complex. It can also lead to many opportunities to enhance returns for your client. Understanding their tax situation helps you choose
Did you realize that not all states charge income tax? There is also a “reciprocity agreement” between the federal government and each state. So, they don’t generally tax each other’s debt. The way a state taxes your client’s income is crucial to buying bonds (or even a bond fund) in a taxable account. The example below takes you through one possible tax situation.
(To keep things simple, we’ll ignore issuer risk, diversification, bond funds, and AMT.)
Say your client lives in California and has
You’re deciding on whether to buy:
You compare the after-tax yield your client would likely receive on each. First, the UST income is federally taxable but not state-taxable.
So if a bond yields 3.5%, your client can expect roughly 2.6% after federal tax. A non-California municipal bond might pay 3%. It is federally tax-exempt (not state tax-exempt), so the yield would be around 2.7%.
Finally, consider a California municipal bond. It enjoys both local and federal tax exemption for California residents. It might pay only 2.8%, after tax — yet the net is higher than it would be for the other two choices.
(The general principle above would also apply to bond funds; however, bond funds’ yields are not known with certainty in advance.)
Imagine that you invest for a client getting ready to retire. You need to know if post-retirement AGI will change significantly. You may be able to time capital gains and other types of income to enjoy the lower of two tax rates. This can be tricky.
The tax code is always changing. Who knows what post-retirement income will be if a client changes cities or takes on a new enterprise? Prudent planning considers (1) what is most probable and (2) a range of reasonable options.
A client may earn a high income now but expect to have a much lower income after retirement. Then you might encourage maximum contributions to any tax-deferred accounts still available.
Also, keep in mind the current 3.8% additional tax on capital gains for high-earners. You may wish to delay sales of appreciated assets until after retirement to avoid this surcharge.
On the other hand, your client may not expect your future tax rates to be lower (either personally or due to the tax code). Then you may not care about tax deferral and feel less constrained when taking taxable gains. The important thing is to have thoroughly thought it out.
Schedule D records any loss carryovers from prior years. An investment might have sold at a loss without sufficient capital gains in the same year to offset it. The first $3,000 of capital losses that remain typically offsets regular income. After that, Schedule D losses carry over during your client’s lifetime. This balance can extinguish future capital gains until depleted.
A net operating loss from a business failure is similar. It also reduces capital gains and even taxable income, but it is not a regular Schedule D item. Knowing about losses on the books or pending losses for that tax year lets you decide. Can you safely sell an asset with embedded capital gains in the current year? Or will it increase a client’s AGI or taxes?
The astute advisor (or tax professional) knows how to offset gains and losses in their client’s portfolio. This means knowing when to — and when not to — pair up investments to reduce or eliminate tax exposure.
To harvest a capital loss for the current tax year, for example, you can’t purchase the same or “substantially identical” security within a certain period (roughly 30 days before or after the sale). Otherwise, that loss may be “disallowed” for Schedule D records.
At this writing, there are at least two popular gold ETFs which hold only gold bullion in a vault somewhere. Should you sell one and buy the other in a “tax swap” transaction, you will violate this rule. Both investments are essentially the same.
An astute advisor (or tax professional) will also understand the netting rules. These apply to capital gains so that they match up appropriately. For example: short-term losses, long-term losses and collectibles losses offset same-type gains.
There is a specific order you must follow to apply offsets in the same tax year. Make an error, and you could end up wasting your client’s short-term losses to offset long-term gains, for example, and thus miss out on the additional tax-saving potential of offsetting short-term gains instead.
Many financial advisers engage in “asset location.” This refers to choosing which account type (taxable, IRA, Roth, etc.) will hold each type of asset because of its tax treatment.
For example, corporate bonds incur regular income tax rates on the interest. Likewise, distributions from a tax-deferred account incur regular income tax rates. Thus when you buy corporate bonds to complement an equity portfolio, you may put them in tax-deferred accounts — as a rule. This way, taxes paid won’t be higher than what is paid on bonds held in a taxable account. And you can let the interest compound through reinvestment.
The client isn’t required to pay taxes until money is withdrawn from the account. This frees you up to place equities in taxable accounts (like trusts). In this case, capital gains rates apply, and you can harvest the losses as needed for Schedule D (as described above).
Some advisers also place the “high octane” investments in tax-exempt Roth accounts. Investments with the highest potential gain over time might escape tax altogether.
These comments present a gross simplification of asset location policies. CFA Institute has published an excellent primer on asset location. See their Investment Management for Taxable Private Investors monograph. Suffice it to say your adviser should understand tax impacts of asset location to advise you accordingly.
As a fiduciary, you want to avoid excessive trading. Increased turnover generally leads to higher commissions. It can incur much higher tax bills when losses do not offset gains as described above. You may think you have a “hot hand” and can time when to buy or sell securities, but even if you succeed, additional taxation can seriously impair the gains and make you look irresponsible.
It is best to build a sensible long-term plan that you can implement and monitor over time. Make only occasional adjustments to (1) keep asset allocation in line or (2) adapt to clients’ changing circumstances.
You may choose an actively managed mutual fund. Remember, the manager’s trading within the fund can also generate taxable distributions.
Mutual funds generally distribute most of their dividend and capital gains income to investors each year. Bond funds usually pay income monthly, while equity and bond funds likely pay out capital gains at the end of the year. What’s wrong with getting income on your investments? Nothing. As long as you understand the tax consequences of the distribution, you can plan accordingly.
When a fund’s board of directors announces a distribution, it also sets an “ex date.” On this date, any new mutual fund investors will not be eligible for the distribution. The mutual fund shares also drop in price by the amount of the distribution.
A fiduciary would be careless to purchase a fund in a taxable account right before getting a portion of the money back as a taxable distribution. In the industry, they call it “buying a dividend.” (Of course, you needn’t worry about distributions to tax-deferred or tax-exempt accounts.)
To avoid buying dividends, you generally must reach out to the fund company. Ask about the upcoming distributions, their amounts and tax character. Then weigh the possibility of share price changes against the risk of buying a dividend. In most cases, you are likely safer waiting if the distribution will come in a few days.
But what if your client already holds funds that plan large distributions? Once you know the amounts and the taxation on them, you can perform a calculation like the following:
Armed with this information, you can decide whether to sell the fund the day before the ex date and then purchase it back on the ex date, or hold it and receive the distribution.
You might go further to see recent price changes for the fund and estimate what the share price increase could be if you were out of the market for a day. Give yourself a decent margin of safety before undertaking additional trades.
As a fiduciary, you are likely not expected to avoid taxable distributions on funds already held. But this is something extra you can do to help the tax picture. A good adviser can help handle these operations for you.
When you select the funds to hold in taxable accounts, there are two things affecting tax efficiency to consider:
By careful selection, you may be able to avoid large distributions in the first place. This is particularly true if you select exchange-traded funds (ETFs). ETFs have a “create/redeem mechanism” that allows the fund to pass appreciated stock on to authorized participants who redeem their ETF shares for stocks or bonds. This arrangement greatly reduces the risk of taxable capital gains at year-end to the remaining shareholders.
Passive funds such as index funds also tend to trade less than active funds. This usually means fewer gains distributions to taxable accounts. Your adviser’s software may make this level of fund analysis quick and easy.
Investors in the U.S. enjoy one hugely complicated tax code. We can thank decades of political wrangling, lobbying and plain old inaction. But complexity brings opportunity for those willing to do their homework. As a fiduciary, you must possess a basic knowledge of how to best position assets for tax efficiency or retain the services of someone who does.
Thinking through the above rules and suggestions, remember the process is not “once-and-done.” Clients’ tax situations morph all the time due to job changes, moves, and updates to the tax code. Partner with a good tax professional or a financial adviser who knows taxes. It can give you the leg up on tax-efficient portfolio management.
Peter Eickelberg currently serves as a Managing Director and Chief Compliance Officer of Alpha Fiduciary, a $600 million+ investment advisor based in Phoenix, AZ. Prior to this position, he led the investment department for a large cross-border wealth management firm that specialized in Canadian migrants, and before that he was a broker with a highly-ranked…
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