Taxes are always a very personal situation, and high-net-worth investors in particular tend to have more complex and varied tax circumstances. Some are business owners who accrue capital gains in their businesses, while others are in high income tax brackets. As financial advisors often tell us, every individual needs personalized attention when it comes to considering how capital gains taxes affect their after-tax performance.
But for the typical advisor, it is often very difficult to provide personalized tax management services if they are dealing with 150 to 200 households, or more. In many cases, advisors try to add value in this area by deploying simple end-of-year tax-loss harvesting strategies that generate some losses to offset gains. However, these strategies tend to be labor-intensive, requiring advisors to manually go account by account, and they tend not to provide consistent personalized value to investors. Depending on market conditions at the end of the year, and the makeup of an investor’s portfolio, their circumstances might not enable them to achieve optimal value from year-end tax-loss harvesting.
Nearly every year, the equity markets tend to experience corrections of roughly 10% at some point during the year, even when experiencing fairly strong performance for the full year. Last year is a good example as the markets were strong throughout, particularly at year-end, but there were also multiple periods of weakness during 2023. So, if an advisor waited until the end of the year to undertake tax-loss harvesting, they would have found many of their clients wouldn’t have had many losses to harvest at that time. However, if they had the ability to conduct ongoing reviews of client portfolios from a tax management perspective, they would have found better opportunities throughout the year to harvest losses rather than at year-end.
A real-life example of something that happened to one of our clients illustrates this point. Back in 2018, the market saw a significant decline of nearly 20% in the last two months of the year and troughed in the last week of the year. The market then rallied very strongly the last week of the year and into January of 2019.
Most advisors that undertake end-of-year tax-loss harvesting do so in early or mid-December so that they get the benefit of the losses for that tax year. When they do that, they often reinvest the proceeds from the losses in an ETF to maintain their market exposure and then sell that ETF after the wash sale period for the securities they sold expires 30 days later, which would be in January of the following year. Unfortunately, this can often have the unexpected consequence of causing significant realized short-term capital gains that following year. Since short-terms gains are taxed at a significantly higher rate than long-term gains, this type of tax management can often be detrimental to the client’s after-tax experience.
We worked with an advisor in early 2019 who had done just that. The advisor was working with a high-net-worth client and manually harvested losses of over $1.5 million in his taxable account near the end of 2018. He then reinvested the proceeds in an ETF to maintain market exposure, and then sold that ETF in January of 2019 and reinvested the proceeds back into the securities that had been sold. Since the market had rallied so strongly, the client experienced a short-term capital gain of roughly $90,000 in January of 2019, resulting in a potential tax burden of nearly $40,000.
That caught his client, who did not want an unexpected tax bill to come due in 2020, by surprise. Had that advisor been using a tax overlay service, the proceeds from the loss harvesting would have been invested more thoughtfully across other model positions and the short-term capital gains would have been avoided. That said, tax overlay services are not without risk, so taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
This is the danger of performing tax-loss harvesting simply for the purpose of harvesting losses—it tends to be a blunt instrument that can have unintended tax consequences for the client, while also causing a departure from a client’s target portfolio allocation and introducing more risk into the portfolio.
Tax-loss harvesting, and other aspects of tax management and planning, shouldn’t be an end-of-year ritual. Advisors need to keep track of tax-loss harvesting opportunities beyond December, while also being thoughtful about how to reinvest proceeds from loss harvesting so unintended capital gains aren’t realized. Outsourcing tax management can enable advisors to seamlessly apply tax management strategies across all their clients’ taxable accounts throughout the year consistent with client-specific tax objectives, allowing them to devote more time to client relationships and service.
Outsourcing tax management to a tax overlay manager can allow advisors to potentially elevate their value in several ways:
• Applying Capital Gains Budgets to Control Exposure—Overlay services available in today’s marketplace can help advisors work with clients to create capital gains budgets which can be applied to portfolios, providing clarity on the capital gains taxes that will be due come April. Capital gains budgets are designed to help advisors and clients control the capital gains in their portfolios, and alert them when they are in danger of going beyond the set exposure. Providing this type of clarity to track and control capital gains exposure is especially useful for mitigating what clients owe on Tax Day and preventing a negative surprise.
• Coordination of Tax-Loss Harvesting Across Multiple Sleeves—Tax overlay services can also help streamline tax-loss harvesting, gain loss matching, gain deferral and other tax management trading techniques across multiple account manager sleeves in unified managed accounts.
• Scalable Growth—Outsourcing certain functions is key for advisors to grow their practices without sacrificing the holistic planning and personal engagement that are key to every client relationship. The outsourcing of investment management led many advisors to outsource models and separately managed accounts, and now the industry is seeing advisors outsource tax management to facilitate scalable growth. The outsourcing of tax management can ensure an advisor’s tax planning capabilities can be provided to every client as their practice grows.
• After-Tax Performance Reporting—Some tax overlay managers give advisors comprehensive presentation and reporting tools to show clients the after-tax benefits of employing the service. Providing clients with a holistic picture of their portfolio, and the after-tax performance if ongoing holistic tax overlay is employed, can strengthen portfolio management and client relationships.
According to Spectrem research (Spectrem is now CEG Insights) from August 2021, 89% of clients expect their advisors to be able to provide tax planning advice, but only 25% of clients actually receive it. Meanwhile, a recent study by Envestnet | PMC, including data from Morningstar and Vanguard, found that tax management can add 100 basis points of value to an all-equity portfolio every year.
The tax optimization of taxable accounts can significantly contribute to an advisor’s value proposition over the long term—and outsourcing this capability can give them the solutions and insights they need to undertake effective tax management for all their clients all year long.
Erik Preus, CFA, is group head of investment solutions at Envestnet | PMC, Envestnet’s portfolio consulting group.