Standing out from the crowd isn’t getting any easier in the investment advisory business. Thanks to the rise of low-cost indexing and computer-driven rules-based strategies to run money, finding ways to distinguish your practice and demonstrate that you offer more than garden-variety advice becomes more challenging every year. But if there’s any low-hanging fruit left to be plucked, some of the ripest can be found in the niche of boosting after-tax returns.
Clients may be clueless about so-called tax alpha—superior investment performance generated through tax-savvy money management. But this is easily explained because everyone understands the value of keeping more of what they earn. It follows, then, that strengthening your relationships with clients by maximizing tax alpha represents a win-win strategy for your business model.
The numbers speak loud and clear: Taxes reduce investment returns by as much as 3% a year, estimates Brian Langstraat, CEO of Parametric, a global asset management firm that specializes in tax-efficient money management. The implication is that poorly run strategy, from a tax perspective, may trail an identical tax-efficient portfolio by up to 3% a year, at least in theory. It’s impossible to reduce taxes completely, of course, but even a moderate improvement of tax alpha can add up to substantially higher performance through time thanks to the power of compounding.
The potential for raising after-tax performance varies for every client. Much depends on the portfolio and individual’s tax situation. But the opportunity is certainly worthy of careful study. Indeed, ignoring this aspect of money management is effectively throwing away significant amounts of money, particularly for clients in high tax brackets with large portfolios.
Consider a Neuberger Berman study that finds the potential boost is more than 4% annualized in the best-case scenario, based on simulating results for a U.S. equity portfolio. That’s a significant increase in relative terms—the S&P 500 Index earned roughly 14% a year over the past decade.
Optimizing tax alpha “is paramount to the relationship,” Brad Sherman at Sherman Wealth Management in Gaithersburg, Maryland, tells Horsesmouth. “After-tax return is the only thing that matters.” It’s all about the math, he explains. “A return of x in a taxable account is irrelevant if you’re paying 52 cents on the dollar.”
Given the headwind, many advisors see the task of maximizing tax alpha as a front-line service. “The biggest alpha I add is after-tax returns and financial planning,” says Mohit Desai at MD Wealth Advisors, Cranford, New Jersey.
The main challenge is that there’s no single way to generate higher after-tax returns. But that’s also a plus because there are numerous possibilities. Therein lies opportunity because the tax-alpha toolkit is broad and deep, providing you with several ways to customize solutions for clients and at the same time provide real-world evidence of your value as an advisor.
Your ability to help clients keep Uncle Sam’s tax bite to a minimum is inevitably a project that must be customized for each client. The list below outlines eight key strategies for pursuing tax alpha. It’s unlikely that you’ll be able to use all of these strategies simultaneously for every client. Indeed, every portfolio, every investment objective is unique. But this much is clear: The more of these you can implement, the greater the potential for boosting after-tax results.
1. Favor indexing over active management
Never say never, but unless there’s a compelling case to use an actively run fund or strategy, passive index products should be the default choice. A tendency to generate above-average performance (relative to active strategies) and low costs are strong reasons to favor indexing. High-tax efficiency is another. For standard, broad-based index funds, portfolio turnover tends to be relatively low, which translates into lesser taxable distributions versus actively run funds with a similar target market.
“I think about tax efficiency more so than most RIAs, and it colors my bias on why I’m more oriented to passive strategies,” says Ben Gurwitz at Financial Life Advisors in San Antonio, Texas.
2. Use ETFs rather than open-end mutual funds
One of the easiest ways to juice after-tax returns is choosing ETFs, which are typically far more tax-efficient compared with an equivalent open-end mutual fund. The combination of an index-based strategy and the tax-efficient design of ETFs, which usually distribute far less taxable distributions versus mutual funds, make these products a no-brainer for maximizing tax alpha.
At the heart of the ETF structure is a mechanism to reduce taxable distributions, courtesy of a unique “in-kind” transfer process for transactions. This method, combined with passive management for most of the products, allows ETFs to maximize tax efficiency and reduce—and in some cases eliminate—capital gains distributions. As a result, these products are especially useful for raising tax alpha in taxable accounts.
If you do use active strategies, try to put them in tax-advantaged accounts (see asset location overview immediately below).
3. Location matters
There’s an old saying in the real estate business that there are only three relevant factors: location, location, location. There’s a case for using the same logic in tax-alpha strategies when it comes to asset location.
A simple example: Hold an investment with taxable distributions in a tax-efficient account, such as an IRA or 401(k), while putting tax-efficient securities—muni bonds, for instance—in taxable accounts.
A recent Vanguard study estimated that up to 75 basis points can be added to investment performance by optimizing the asset-location decision. The biggest opportunities on this front are likely to be found with clients in high-marginal tax brackets.
4. Tax-loss harvesting
How you trade matters just as much (if not more) than what you trade for minimizing taxes. Enter tax-loss harvesting, which focuses on swapping securities holdings with losses for equivalent but not identical proxies. A carefully managed tax-loss harvesting strategy can add as much as 1.10% a year to a portfolio’s performance, according to a recent study.
As an example, let’s say you bought the Vanguard Total U.S. Bond Market ETF (BND) in January and it’s trading a loss in December. Also assume that you want to continue to hold a position in the bond market. A tax-loss trade allows you to book the loss without giving up the bond-market allocation.
Here’s how it works. Step one: Sell BND to record a loss. Immediately buy a similar ETF—iShares Core U.S. Aggregate Bond ETF (AGG), for example. The net result: You generated a tax loss that can be used to reduce a taxable capital gain created elsewhere in the portfolio while maintaining exposure to the bond market.
Be careful to satisfy the IRS wash-sale rule, which says that you can’t book a loss and buy a “substantially” identical security within 30 days before or after the sale. The government has never clearly outlined the definition of “substantially” identical, but most financial and tax advisors say that swapping funds with different tickers and/or track different indexes will satisfy the IRS.
5. Take advantage of tax-lot management when selling
With this strategy, you’ll exploit opportunities by targeting specific lots of previously purchased securities during sales transactions.
For example, imagine you bought 1000 shares of the SPDR S&P 500 ETF (SPY) in January and another 1000 shares in August in a taxable account. During that time the ETF continued to rise and by November you are sitting on a sizable profit overall. But then you get a call from the client—she needs to sell half of the position for an unexpected expense. By specifically selling the second lot (purchased in August) the taxable gain is lower than if you were to sell the January lot.
A related technique is account-redemption management. For this strategy, sales are favored in taxable/tax-efficient accounts (if possible) while avoiding redemptions in relatively tax-efficient accounts, such as an IRA.
6. Tax-savvy rebalancing
The idea here is to use any distributions from investments to facilitate portfolio rebalancing, thereby minimizing if not avoiding taxable sales altogether. As a basic example, let’s say a client has a mix of 60% equities/40% bonds portfolio that’s due for rebalancing at the end of the year, when the underlying funds will pay out distributions. The goal: Use the distributions to finance (or at least partly finance) any rebalancing-related purchases. To the extent that this reduces the need to sell securities (and possibly book a capital gain), the taxable impact will be softer.
7. Use longer-term investing horizons
Short-term capital gains are taxed at a higher rate than long-term gains, so another way to boost tax alpha is to favor longer holding periods. The current tax rule: Short-term is defined as holding assets for one year or less; holding periods beyond one year automatically qualify for a lower capital gains tax rate.
8. Charitable giving
For clients motivated to give to charity, there is another opportunity to lower the tax bite. Donating highly appreciated securities, for instance, can minimize taxes that are as high as 35% on realized gains, based on the combined federal, state and local rate for some investors. Cash donations to IRS-recognized charities are also deductible.
There are limits, of course, and those limits vary depending on the client’s tax profile. Being aware of the limits and how donations will (or won’t) affect taxes overall is necessary before advising clients. Nonetheless, it’s clear that developing a plan for donating assets with a tax-savvy strategy can be a potent tool for creating substantial tax alpha.