In a memorable moment in the film The Graduate, a neighbor pulls Dustin Hoffman aside at his college graduation party. The neighbor, Mr. McGuire, tells Hoffman’s character, Benjamin Braddock, that he has “just one word” for him: plastics.
I have just one word for you: taxes.
As my colleague and notable investor Paul Samuelson has written, no factor is as influential as taxes in determining how much money retirees will have to spend or leave to heirs. And, advises Paul, minimizing taxes with tax-smart asset location is the best way to improve retirement outcomes for clients.
Recent News Trains Light On Asset Location
Asset location isn’t half as well known among investors as its cousin, asset allocation, but recent events are changing that.
Asset location is the practice of choosing what investments to place in what accounts based on the tax treatment of the accounts with the intent of improving outcomes across an entire portfolio. According to Paul, tax-smart asset location is the most overlooked lever available to investors. Ignoring it is costly.
As the Wall Street Journal reported recently, some investors are furious that capital gains distributions from some Vanguard Target Retirement Funds brought on “painful tax bills.” That’s because the investors held the funds in taxable brokerage accounts and not in tax-advantaged accounts, like 401(k)s or individual retirement accounts (IRAs).
The investors say they weren’t sufficiently warned target-date funds are manufactured for tax-advantaged accounts. They looked at them as sensible choices to place money they didn’t want to actively manage after they’d maxed out savings in tax-advantaged accounts.
In other words, investors were unaware of the importance of asset location in managing their tax exposure. One Vanguard investor told the Journal he had about $3.6 million in one fund and now owes about $150,000 in federal and state taxes.
The Vanguard complaints motivated Massachusetts regulators, who have given BlackRock, T. Rowe Price, American Funds, Fidelity and Vanguard until February 9 to provide information about the firms’ marketing practices and investor education related to target-date funds.
Inflation Throws Gasoline On The Tax Fire
Prices of food, cars, housing and more have skyrocketed. Twelve-month inflation hit 7% in December, reaching a 39-year high. This worries everyone, especially those who no longer earn wages and depend on savings to cover everyday expenses.
Inflation plays another cruel role: Increasing people’s tax bills and effectively shrinking their retirement income. Inflation could mean higher bond yields, triggering higher taxes for bondholders. Stock investors may find they pay higher taxes when corporate earnings benefit from higher prices.
Inflation’s protracted reappearance means financial advisors must leverage their toolsets for tax efficiency to:
• Protect clients from paying unnecessary taxes, and
• Quantify and guide the short- and long-term savings clients can realize through tax efficiency.
Successful Firms Have Called The Next Play, And It’s Tax Efficiency
I talk with leaders in the financial advice and wealth technology space in my weekly podcast, WealthTech on Deck. Len Reinhart, founder of Lockwood Advisors Inc., and John Thiel, former head of wealth management at Merrill Lynch, and others observe that people are making life-changing decisions about retirement more quickly and consolidating assets at record-breaking levels due to the Covid-19 pandemic.
The happy consequence of that, combined with strong market returns for the past many years, is that advisors and firms—Morgan Stanley, Merrill Lynch, Ameriprise, Raymond James and many registered investment advisors (RIAs)—are reporting record assets under management and positive inflows.
Retirees and those about to join them are fretting about inflation and taxes. They are old enough to understand that markets undergo corrections, and many have experienced high taxes and inflation in their lifetimes. They want to hear from you how to retain as much as they can in the face of economic uncertainty and volatility.
Ben Huneke, who heads all product and platform at Morgan Stanley, recently told podcast listeners and me that he believes today’s circumstances—income disparity and the upcoming transfer of baby boomers’ wealth to their heirs—mean politicians will eventually change tax laws. Morgan Stanley, he said, has already—and continues to—invest in technology that helps advisors be tax efficient in locating assets and withdrawing them.
Let’s be honest, our industry has only recently realized that the investors we’ve cultivated for 40 years have reached a tipping point. Now they are converting from lifetimes of accumulation to the next few decades of decumulation. And it’s up to financial advisors to help them keep as much as they can of what they’ve saved.
That demands helping them minimize their tax bills through tax-smart asset location and withdrawals, tax harvesting and rebalancing across the full portfolio, and other tax-wise practices. Watch this space for upcoming advice from Paul Samuelson on five ways to improve tax alpha for your clients.
Are you up for this task? Do you have the technology to provide your clients with tax alpha at scale? As the number of retirees grow by the day, these issues of taxes and inflation will be with us for a very long time.
Jack Sharry is co-chair of MMI's Digital Advice Community. He serves on the Next Chapter Advisory Council, hosts the WealthTech on Deck podcast, is the author of the book Authentic and Ethical Persuasion, and is executive vice president of LifeYield.