Capital gains tax considerations impact investors of all sizes—especially long-term investors whose time horizon exceeds 10 years, like those saving for college or a second home, those managing asset pools designed to benefit future generations or charities, or those investing for retirement with an investment portfolio beyond the traditional pre-tax 401(K) or IRA.
The current market growth cycle is long by post-war standards and has produced significant asset value increases since the market bottom in March 2009. As a natural result, investment portfolios have a high level of unrealized capital gains and few offsetting losses, which makes every portfolio adjustment more expensive from a capital gains tax point of view.
With the maturity of the current market cycle and the return of volatility, investors are confronted with the choice between over-exposure to market risk or over-exposure to capital gains taxes. To best serve their clients, financial advisors need to consider—and clearly present—strategies that strike a balance and maintain alignment with the client’s goals and risk profile.
Balancing Act
The truth is, portfolios not regularly rebalanced have likely fallen out of line with previously set goals and risk profiles, and need to be reassessed sooner rather than later. This rebalancing will often trigger capital gains consequences. However, this nominal tax consideration should not deter investors from properly positioning portfolios to combat heightened market volatility. In the current environment, the potential for negative impact from a misaligned portfolio can far exceed the cost of marginal taxes on realized capital gains.
Many investors and their advisors are making portfolio adjustments to reduce risk exposures in the current environment to hedge against increased volatility, more uncertainty about geopolitical affairs and the declining potential for continued market gains without interruption. Advisors are increasingly positioning portfolios more defensively and rebalancing to take risk off the table, which typically results in reducing equity exposure in favor of more risk-averse assets like bonds or other cash-like allocations.
Investor portfolios may have a variety of long-term asset allocations based on the goals for the money, the amount of time before the money is used for its intended purpose and investor risk tolerance. For purposes of retirement, multi-generational trust and estate planning, or philanthropic interests, a typical portfolio would have 60 percent or more allocated to equity securities. A client saving for college may benefit from a more conservative allocation with about 30 percent equities and 70 percent fixed income, whereas a client saving for a second home may benefit from a 50/50 split. Advisors must closely consider the goal of each client portfolio and allocate accordingly based on risk tolerance and the allotted time horizon for return. As risk reduction becomes more important in the current market environment, advisors will often recommend a modest underweighting to riskier asset types. These tactical asset allocation tilts are beneficial to long term results and the overall risk profile of any investment portfolio.
Consider The 1 Percent
Because adjustments to offset increased volatility and market risk are appropriate in most portfolios this year, realized capital gains may be higher than advisors and their clients originally planned. That said, it’s important to remember the additional tax cost is small compared to the potential cost of too much risk exposure. Consider it cheap insurance. With the significant market gains experienced since 2009, it is sound practice to realize some of those gains and position portfolios for the next phase of the market cycle.
We believe diversified portfolios, comprised of equities, fixed income and alternatives, should expect up to 5 percent of the total portfolio value in capital gains realization annually on average. At this rate of gains recognition, investors can expect to pay a capital gains tax of about 1 percent of the total portfolio value annually—truly a small price to pay relative to the risk exposure of an unbalanced portfolio, and a compelling data point to convey to clients.
Look For The Loss
Even with a balanced portfolio, it’s prudent to manage capital gains liability over time by offsetting gains and losses where possible. In partnership with a tax professional, advisors and their clients should set an annual budget based on long-term market growth expectations, various estate planning structures or capital losses available outside the investment portfolio. Typically, the 5 percent average annual capital gains budget mentioned above is sufficient to allow for normal portfolio management and rebalancing. Many investors will view the budget as set in stone. But, it’s an advisor’s job to help clients understand the need for flexibility given current market conditions and exposure to risk. In the near-term, advisors can help clients minimize the impact of capital gains by looking for losses elsewhere in the portfolio. Long-term, investors can recover large capital gains in a given year via lower capital gains in other years, such as during the next bear market.
Have The Conversation
Financial advisors should consider the above and plan to structure conversations with clients to clearly explain the risks and overcome the natural hesitation clients may feel at the prospect of increasing their tax exposure:
1. Discuss the current economic climate, market volatility and variability of return.
2. Explain the capital gains tax consequence relative to return projections, agree and adjust capital gains budgets accordingly.
3. Identify ways to offset losses in the immediate investment portfolio and beyond.
Given today’s volatile market environment, advisors and investors should focus on properly balancing portfolios and worry less about a 1 percent tax consequence. It’s most important to maintain an appropriate allocation for the market circumstances we’re currently facing, and not allow capital gains recognition to prevent striking the right portfolio positioning. From my perspective, it’s well worth a few more tax dollars.
Dan LaPlante, CFA, is the chief investment officer for private wealth management at Citizens Bank.