While it may be true that death and taxes are inevitable, we all know that a healthy and stress-free lifestyle can prolong life and that taxes may be minimized with proper planning. I'll leave the health issues to the medical professionals. It is our job as financial planners, however, to help our clients avoid unnecessary taxes on their portfolios. This article will be limited to the discussion of reducing taxes on portfolios and is aimed at advisors who invest the bulk of their clients' assets in mutual funds.
While our firm has chosen not to provide tax preparation, we do believe that reducing our clients' tax burdens (and increasing their after-tax returns) is a core service that our clients appreciate. When managing your clients' assets, there are a number of strategies (beyond the obvious recommendations such as buying tax-free bonds and tax-efficient mutual funds) that can significantly reduce the taxes they pay. Moreover, some of these tactics would be difficult for most clients to implement on their own.
As a result, you may be able to increase your value added and their financial peace of mind. For many of you, the following strategies may be simply a refresher. However, when we discuss them with potential clients, we learn that very few advisors actually implement these tactics. The following are tax strategies you may want to consider to increase the after-tax returns on the assets you manage:
Allocate portfolios globally rather than by account. In this manner, you can place tax-efficient assets (such as index funds, ETFs, etc.) in taxable accounts and the least efficient ones (such as REITs) in tax-deferred accounts. Why would anyone not implement this strategy? The only reason we can come up with is that it makes rebalancing easier. Anyone who has had to rebalance portfolios that are globally allocated knows how time-consuming this may be. However, our job is to serve our clients and not ourselves. If it is in the best interests of our clients to allocate globally, I believe it is our fiduciary obligation to do so. Where will we hide when those large dividends are declared by REIT mutual funds and we are asked why these funds weren't in IRA accounts?
Don't pay taxes on gains that you don't have. We all know that one of the disadvantages of owning mutual funds is that capital gains are distributed regardless of the gain (or loss) experienced by the owner of that fund. Last year investors saw large capital gains distributions, and that created an opportunity for us to reduce many of our clients' taxable incomes. For example, assume that your client had invested $50,000 in a fund and at the end of the year the value was still $50,000. However, the fund company is declaring a capital gain distribution of $5,000. That client would be responsible for paying tax on money she had not made. We assure our clients that we will see to it that they never pay taxes on gains they do not have. In some cases, our clients may have actually lost money and, despite that, if nothing is done they will need to pay income taxes on an investment that has a net loss! In order to avoid that, our firm produces a spreadsheet in December of each year that lists our clients' unrealized gains or losses in each fund they own. This is compared to the gain they would experience if they held the fund and accepted the distribution. With some exceptions for small differences, the fund is sold before the distribution if its effect is a better tax result for the client. As with all tax harvesting (see below), a similar fund is purchased (and we are careful to do this after the distribution date for the new fund) so that our client is not out of the market.
Whenever possible, rebalance with money on which you have already paid taxes. Reinvesting dividends and capital gains may be appropriate if you never intend to rebalance your clients' portfolios, but it will incur unnecessary taxes for them if you do plan to rebalance. So I suggest that you take all distributions in cash in taxable accounts (we still reinvest dividends and capital gains in tax-deferred accounts). Let's assume that you are reinvesting all distributions and you find that a mutual fund that your client owns with a position of $50,000 (the cost basis is $25,000) needs to be reduced to $40,000, so you sell $10,000 and pay a capital gains tax on $5,000 (the cost basis is 50% of the value). The federal tax will be $750 (15%). We will also assume that distributions from the fund during the previous year (which were reinvested) equaled $5,000. If you took that distribution in cash, your fund would now be worth $45,000 (assuming there is no gain or loss) and the cost basis would be $20,000 (reduced by the $5,000 distribution, since it was not reinvested) or 44.44% of the fund's value (decreased from 50% if reinvested). In order to rebalance the portfolio, we would only need to sell $5,000 to reduce the holding to $40,000, so your client would pay a capital gains tax on $2,778 (55.56% of the sale) and a federal tax of $416.70. You have saved your client $333.30 in taxes. When we apply this strategy across the entire portfolio, it can result in significant tax savings for your clients. Of course, the downside is that it may result in higher transaction fees, but we have found that the tax savings more than compensate for these expenses.
Volatility can be your friend. It has always puzzled me that so many financial planners and money managers wait until year's end to do tax harvesting. Of course, markets can be volatile throughout the year, so tax harvesting needs to be done when we have the opportunity. Recoveries can be rapid, and if we wait until the end of the year, we may discover that the losses we could have taken earlier are no longer available. This year's volatile market is a typical example of what waiting may cost your clients. Of course, if you wait 30 days to get back in, your clients may not experience the gains of a quick recovery, so it is extremely important that the money from the investments you sell for tax purposes are reinvested in similar investments.
As mentioned above, the disadvantage of implementing these strategies will be that they are much more time-consuming than simply being passive. However, our clients don't pay us to be passive. They pay us to, among other things, enhance their after-tax returns. Our advantage is that these tactics will be extremely difficult for our clients to implement on their own.
Another client referred one of our best clients to us several years ago. He was a do-it-yourself investor, but when the client who referred him told him about our tax strategies, he asked for my phone number. The primary reason he hired our firm was these tax-reduction policies we are discussing. I may not be able to predict what markets will do, nor will I claim to my clients that I can. However, I do have some control over the taxes they pay, and implementing these strategies is one more value added for clients.
Yes, taxes like death are inevitable, but we have the ability to assure that our clients do not pay more than they need to by managing their assets in the most tax-efficient manner.