When a new client comes to me, I almost always make huge changes to their portfolio. Before deciding on those changes, however, I first dig into their tax returns to learn about both the client and their investments. (Recent commentary on the presidential candidates notwithstanding, I always find tax returns to be revelatory.)

Here are six things I look for and how they impact my recommendations.

1. Behavior. When I interview a potential client, I ask how they behaved during the 2008-09 market plunge. Most respond that they stayed the course or bought more stocks after the collapse. But many times that’s merely wishful thinking. I’ve had clients tell me they were disciplined investors only to see seven-figure, tax-loss carry forwards on their return.

When I ask about the loss, more often than not it’s because they panicked and sold. Each time, the client assures me that they have learned their lesson and won’t do it again. And each time, I tell them that past behavior is the best indicator of what they will do during the next plunge. Then I steer them to a more conservative portfolio or at least get them to wait until the next bear market before going for an aggressive strategy.

2. Churn. Turnover typically costs the client in taxes by paying higher rates in both short-term and long-term capital gains. Taxes are costs too, and more taxes lead to lower returns. And there is another cost associated with churn. Higher turnover is associated with more performance chasing and lower returns, even before taking tax inefficiencies into account, research shows.

3. Tax efficiency. Sometimes, I notice huge capital gains, but the client hasn’t sold a thing. For example, I saw a $63,000 recognized gain on a client’s 2015 tax return from one fund, Columbia Acorn Select Z (ACTWX). The gain represented 30% of the client’s holdings in the fund, but she hadn’t sold a single share. This fund passed on capital gains even though it declined in value that year. I call it the mutual fund tax trap. Churn, be it the client's or the funds, creates tax inefficiencies. Fund inefficiencies are a much harder, more painful problem to solve for the client. The solution is usually to sell the tax-inefficient fund and move to one that is more efficient. That means paying taxes sooner to lower the taxes later.

Advisers can learn quite a bit from their clients' tax forms. (Bloomberg News)
Advisers can learn quite a bit from their clients' tax forms. (Bloomberg News)

4. Performance. My clients know that few portfolios beat the lowest cost broad index fund returns. I don’t typically benchmark their past performance to the broad indexes, but I often give them general feedback on returns. For example, I’ll note the Vanguard Total Stock Index Fund ETF (VTI) has gained 13.88% annually over the past five years and 7.08% annually over the past 10 years, as of Oct. 21, 2016. I’ll contrast that with the small unrealized gain on their statements and note the little or none realized gains on their tax return.

There may be other explanations (such as a huge gain recognized the year before) but usually this means their past strategy has underperformed the market as a whole.

5. Deductions. I check to see if clients are getting the full use of their itemized deductions and usually they aren’t. Sometimes, their high income causes some of these deductions to be disallowed in what are called phase downs. But others, primarily those who are retired, may find they are using those deductions just to get the standard deduction. The client, in either case, actually gains tax efficiency by paying down or paying off the mortgage. Other forms of tax efficiency can come from making a required minimum distribution directly from an IRA without worrying about getting the full value of the deduction, or even adverse impacts from higher income such as the impact on Social Security or Medicare premiums.

6. Marginal tax rates. This may seem as simple as taking the taxable income and looking at federal marginal tax brackets but it’s not. Are dividends and long-term capital gains being taxed at 15% or 20%? Is the client being hit with the 3.8% net investment income tax on top of that? Perhaps the ugly alternative minimum tax is making things even worse. Of course, state tax rates and the interaction (such as deductibility of state taxes on federal returns) between state and federal taxes is critical.

But for a retired client, there could be some opportunities. These include selling some securities to recognize long-term gains at a 0% tax rate or perhaps doing one or many Roth conversions.

Understanding the client’s true marginal tax rate is critical not only in figuring out what to sell to create the better portfolio but also what to hold. Should the client have tax-free municipal bonds? Many times I see clients trying to pay less in taxes rather than the better goal of making more after taxes.

Finally, if the client is caught between holding an expensive, underperforming fund and paying a huge capital gains tax if they sell, the solution is often to contribute the asset to a charity. The charity can then sell the fund without tax consequences to them.


I tell clients they don’t want to pay me to create a theoretically correct portfolio that doesn’t take into account how much they will pay when I change their portfolio. Clients always agree because taxes are real.

With these six insights and more, I work with the clients’ CPAs in developing the new portfolios to try to achieve tax alpha. A CPA typically has a client’s tax return in a software program and can easily run some scenarios to see the taxes currently being paid to save fees and taxes later. They can estimate the tax impacts of selling securities. For instance, would it be better to sell all at once (ripping the Band-Aid off) or more slowly over a period of years?

I can then work to design the new portfolio to locate tax-inefficient assets, such as bonds and REITs in tax-deferred accounts, and buy tax-efficient, broad, low-cost stock index funds in the taxable account. If they have enough room in the tax-deferred accounts to buy taxable bonds, there is typically no need for any tax-free munis in the taxable account.

Other parts of tax alpha can include strategies like Roth conversions and even multiple Roth conversions. I’m a believer in tax diversification so having some taxable, tax-deferred, and tax-free money provides some protection against tax law changes.

If the clients are in the accumulation stage, tax-efficient rebalancing is crucial. This can be accomplished by putting new money into underperforming asset classes and selling high-performing asset classes in a tax-free or tax-efficient way. If the clients are in the withdraw phase, then taking funds to live on is key. Recognizing income can often have adverse consequences on one’s Social Security, Medicare, or subsidies on the health insurance from the Affordable Care Act. On the other hand, taking out money from IRAs or 401(k)s before one reaches age 70 1/2 may result in paying taxes sooner but at a lower rate.

I’ve always said investing is simple, but I never said taxes were.

Building tax-efficient portfolios and creating strategies from the client’s current portfolio is perhaps the largest single contribution we can make to our clients’ well-being. It’s something no robo adviser could ever hope to do. It’s a value add that can result in referrals from both a client and their CPA.

Allan S. Roth

Allan S. Roth

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colorado. He also writes for The Wall Street and AARP The Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.