The old adage about investing remains the gold standard for portfolio management—“it’s not what you make, it’s what you keep.” Each year, as clients receive 1099s for their investment accounts, the issue of taxes from investment holdings—capital gains, income, mutual fund distributions, etc.—generate a discussion with their advisor.

While asset allocation and explaining return dynamics and risk mitigation have long played a central role in advisor/client relationships, a significant portion of the “what you keep” comes down to taxes. Not all clients receive a truly comprehensive tax impact discussion, but it’s become essential and when it’s combined with portfolio planning, it’s an invaluable part of the partnership.                                                          

More wealth managers are recognizing that advising clients on another layer of diversification, called asset location, adds such value, that it’s become a differentiator for advisors who have that expertise. This is why a growing number of CPAs and tax professionals see an opportunity to move into providing wealth management, both to existing clients and new ones.

For financial advisors, effectively navigating clients through tax-consideration conversations can add a substantial amount to the advisor/client relationship. While tax considerations can oftentimes be very complex, there are some devices advisors can use to help clients visualize their options.

The Tax Protection Triangle

The easiest way to explain how taxes impact a client’s portfolio is to look at the various strategies in three separate buckets based on how they are taxed. Each is taxed very differently, and how much a client actually keeps over time is not inconsequential, particularly as the portfolio grows. It’s the greatest proof point that investing is not just about what you invest in, but also very much about which bucket the holdings go—and that’s where the benefit of having a CPA trained financial advisor truly becomes apparent.

Bucket 1 (Tax Me Always):

Investments made in this area are made with after-tax dollars, meaning federal and state taxes have been collected on earnings before remaining funds can be invested. Over time, this is where a client sees the most frequent ongoing tax liability, as interest, dividends and short- and long-term capital gains are all taxed annually as recognized. This is the area of the account that should be managed with prudence and close calculation from a tax-efficient standpoint. Minimizing short-term trading, tax-loss harvesting, etc. can all be part of the strategy. The benefits to investing in this arena include maximum product availability as well as liquidity.

Bucket 2 (Tax Me Later):

Investments made in this area are funded with pre-tax money, meaning more of each dollar earned can go to work. Investments reside in tax-deferred accounts, such as traditional IRAs, 401(k)s or 403(b)s, and provide some of the best opportunities to invest for the future while deferring tax implications for a very long time. During the period of investment, gains are not subject to taxation, leaving again more capital available to grow. Ultimately, when these funds are withdrawn, they are 100 percent subject to ordinary income tax rates. Additionally, there are IRS restrictions on funding and withdrawals.

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