With capital gains tax rates increasing in 2013, investors are likely to have to turn over an even larger portion of investment returns to the IRS. Fortunately, there are steps financial advisors can take to mitigate the impact of taxes on their clients’ investment returns. Taxes may be an unpleasant topic for clients, but taking a proactive approach to the issue is one very important way to help broaden and strengthen client relationships.
Despite the fact that tax rates have been at historically low levels, taxes are taking a significant bite out of investors’ returns. A study by Lipper found that taxes decreased mutual fund investor returns by over 1% per year for the 10 years ending in 2009—almost as much as the impact of fees. Yet while clients and advisors place a tremendous amount of focus on fees, worrying about handfuls of basis points, the impact of taxes is often neglected entirely.
With higher tax rates and all of the discussion of taxes in the popular media, it’s unlikely that clients will continue to turn a blind eye to taxes. Instead, they are likely to increasingly ask advisors to outline ways to manage this issue. With the increase of capital gains and dividend rates to 20%, higher ordinary income rates for wealthier clients and the additional 3.8% tax on investment income to help fund the healthcare bill, taxes will likely erode even more of investors’ returns.
Other research shows the impact higher tax rates can have on investors’ after-tax returns. Figure 1, from analysis MPA conducted on a sample of domestic and international equity strategies1, illustrates the increased tax drag that would have resulted if the new rates going into effect in 2013 had been in place over the nine-year period from 2004 to 2012. With tax rates at the levels in place at the end of 2012, taxes decreased investor returns by an average of 1.5% over the previous nine years. The new rates enacted by the American Tax Relief Act of 2012 would have resulted in 2.1% reduction over the same period.
Unfortunately, it is unlikely that the agreement reached to avert the fiscal cliff will solve the long-term fiscal issues we face. Many industry experts believe that some combination of further spending cuts and increased tax revenue still looms on the horizon.
Challenges, however, frequently present opportunities, and fortunately there are tools that today’s advisors can use to help reduce their clients’ tax burden. One of the most important of these may well be the increasingly popular Unified Managed Account. Many of these programs include a robust tax management overlay to help maximize each individual client’s after-tax return. These techniques can include proactive tax-loss harvesting throughout the year to offset gains, deferring the realization of gains until they qualify for the lower long-term capital gains tax rate, selecting the optimal tax lot when executing a sale and avoiding wash-sale rule violations. The wash-sale rule prevents taxpayers from using realized losses to offset gains when they purchase the same security within 30 days. The coordination provided by overlay managers across a client’s entire portfolio makes this much easier to control.
Separately managed accounts have long offered the potential for enhanced tax management, but significant progress has been made over the last decade as overlay managers have incorporated more practices to fully capitalize on this opportunity. These techniques are especially effective within unified accounts, as the overlay manager coordinates activity across a client’s entire account. This provides an especially effective way to provide clients with tax-efficient equity exposure.
Re-evaluating municipal bond strategies may also be appropriate. Taxable fixed-income securities typically provide higher yields, but with that income being taxed at a higher rate, lower-yielding municipal bond securities or strategies may result in better after-tax returns.
Asset location is another important consideration in a comprehensive tax-aware financial plan for clients. The process of asset location involves deciding which assets to place in which accounts. Optimizing the location of assets by placing tax-inefficient strategies or vehicles in tax-deferred accounts can have a material impact on a client’s tax liability and after-tax returns. This often results in significant amounts of equity exposure in taxable accounts, underlining the importance of figuring out a way to provide that equity exposure to clients in a tax-efficient manner. Historically, index-based strategies provided one of the few options for doing so. These remain a good option for many clients, but for clients and advisors who wish access to actively managed equity strategies, Unified Managed Accounts are now an excellent alternative as many offer the combination of active management and the tax management techniques described previously.
Taxes may be one of clients’ least favorite topics, but in the context of investing they are extremely important. Advance planning can help reduce a client’s tax liability and mitigate the unpleasantness of surprises when tax returns are filed. This is a valuable service advisors can offer clients, and because proper tax planning requires a discussion of a client’s entire financial picture, it can also serve as a useful catalyst tobroaden the scope of an advisor’s relationship with his or her clients.
Figure 1: 2012 tax drag calculated by MPA using 35% top tax rate for ordinary income and 15% rate for capital gains and dividends. 2013 tax drag calculated using 43.4% ordinary income rate (39.6% top tax rate plus 3.8% Medicare tax on investment income) and 23.8% for capital gains and dividends. Tax drag was calculated by subtracting the after-tax return from the pre-tax return for each strategy for each year, applying each set of the two tax rates to the actual returns of the sampled strategies. Tax rates were applied retroactively from 2004 to 2012. The number of sampled strategies ranged from 6 to 9 depending on the year and was driven by the availability of historical transaction activity.
Curt Overway is president and portfolio manager with Managed Portfolio Advisors, a division of NGAM Advisors LP. Based in Oakland, Calif., Managed Portfolio Advisors offers overlay management, product development and portfolio construction capabilities. Overway is also the president of Active Investment Advisors, another division of Natixis also based in Oakland, which specializes in managing index-based separate account solutions.