Tax Day has come and gone.
As advisors to high-net-worth individuals and families, tax planning is a year-round priority. Clients have wide-ranging objectives that include everything from transferring large amounts of money to younger generations, to minimizing their portfolio’s correlation to the overall market. So, we get asked about tax risk and implications with a certain urgency.
This is what I tell clients to assuage their anxiety: Taxes are not something to be afraid of; they’re something to be aware of. If you’re feeling stressed about reckoning with the tax exposure in your portfolio, here are some basic considerations you can make now and throughout the year to guard against any lingering fears of unseen liabilities or unclaimed benefits before Tax Day rolls around.
Remember the Bigger Picture
Most investors don’t think about their taxes too deeply outside of tax season. But the downside is that the sudden onset of tax season can leave clients vulnerable to making irrational portfolio investment decisions.
A U.S. Trust Insights on Wealth and Worth survey cited in Financial Advisor found that 55% of high-net-worth investors say, “it’s more important to minimize the impact of taxes when making investment decisions than it is to pursue the highest possible returns regardless of the tax consequences.” In my professional view, this is irrational.
It’s important to remember that taxes are but one aspect of a portfolio. You should not sacrifice asset allocation to protect clients from potentially paying more in capital gains taxes. More importantly, the reason they’re investing in the first place is to generate after-tax returns. Don’t let your after-tax returns suffer simply because clients are afraid of paying taxes.
As one of my partners likes to say, “It’s not what you make, it’s what you keep.” If you are keeping more after paying taxes, improving the asset allocation and diversification of your portfolio, that seems like a no-brainer. In most scenarios, paying taxes means you made money.
Reducing Your Tax Exposure Is Not Actually That Hard
On the equity side of the market, one common way investors minimize their tax exposure is by owning passive ETFs instead of actively managed mutual funds. Mutual funds are naturally the less tax-efficient vehicle of the two due to their creation of more taxable events.
But if your client's desire is to beat the fund benchmarks, and they’re able and willing to take on added risk, consider replicating a mutual fund with individual stocks in a portfolio. Provided they have the capital to duplicate the exposure of whatever they’re targeting, they can even replicate the indices by owning all the individual stocks.
This is a technique known as separately managed accounts or “SMA.” The active management of individual stocks, while potentially resulting in higher fees compared with owning passive ETFs, helps us utilize ongoing tax loss harvesting to take advantage of volatility and the ever-changing equity market valuations. It also means that your client's cost basis in a stock is the price you paid for it, not what the mutual fund paid for it. Should that mutual fund choose to sell Apple after your client gets in, you will be responsible for the tax on that gain since 1990.
On the fixed income side, some investors (especially those in low tax brackets) may sacrifice the returns of higher-yielding bonds in favor of owning tax-free municipal bonds. Remember, it’s OK to pay a tax if net after-tax return is going to be higher regardless. This is a common tax avoidance behavior we see in investor portfolios.
I’ve written before about the benefits of alternative investing. While many alternatives can be highly taxed, the benefits (such as diversification) can potentially outweigh those risks. In our case, we feel strongly about the value in private equity, real estate and private debt despite their tax exposure. And when the situation permits and justifies it, we will own those assets inside of retirement accounts or other tax-advantaged vehicles available to high-net-worth investors.
Tax Rates for High-Net-Worth Individuals Are Lower Than Before
Remember the Tax Cuts and Jobs Act? Seems like a lifetime ago when it was signed in December 2017, but the first tax filings that will reflect the legislative changes have finally come around.
On top of reducing the marginal tax rate for the highest bracket from 39.5% to 37%, the act also doubled the gift, estate and generation-skipping transfer tax exemptions from $5.6 million to $11.2 million ($22.4 million for married couples). That new rate will apply until 2026, at which point it will revert to the prior inflation-adjusted rate.
Planning for taxes is a wise decision every investor should undertake. Help your clients remember that paying taxes isn’t always a bad thing; so, encourage them to focus on after-tax return and take advantage of tax-efficient structures when available.
Aaron Hodari, CFP, CIMA, is a managing director at Schechter, a boutique, third-generation wealth advisory and financial services firm located in Birmingham, Mich.