If there’s one thing every client wants to do, it’s to make more money after taxes. Advisors can add a great deal of value for clients when it comes to optimizing their tax tactics.
Here are eight strategies to generating tax alpha for your clients, from conventional practices to more-unusual off-label product moves. Tax law is complicated, and these strategies can be as well, but making the effort can help advisors differentiate their practices.
TRADITIONAL TAX ALPHA
1. Product selection – With stocks near an all-time high, active mutual funds are passing through gains to clients. The average turnover of active equity mutual funds is 63%, according to Morningstar Direct.
This creates both short- and long-term taxable gains, and also results in lower returns even before taking into account these taxable consequences.
Even formerly hot active mutual funds can get into a death spiral, creating a tax trap. For example, the Columbia Acorn Z (ACTWX) lost 0.44% in 2015, but passed on a $7.14 per share capital gain when the fund had to sell stock to honor redemptions as investors fled.
Broad stock index funds of the mutual fund or ETF variety have little to no turnover, and leave you and your client in better control of when to recognize gains.
2. Asset location – Risk is determined by asset allocation and product selection. Once this is done, choosing the right tax wrapper is crucial.
Some assets are best located in taxable accounts and others in traditional tax-deferred accounts. In general, tax-efficient vehicles with high growth potential, such as stock index funds, belong in the taxable accounts.
That’s because the dividends are taxed at lower rates and the client is in control of when the gain is recognized. If owned for over a year, the gain is also taxed at lower long-term capital gains rates.
In fact, under current tax law, no tax on the unrealized gain is ever paid if the client is in the 15% tax bracket upon retirement, donates appreciated stock to charity or passes the asset on to heirs via the step-up basis.
On the other hand, owning stocks in the traditional IRA or 401(k) accounts eventually turns what would have been a tax preference item into ordinary income, thus typically resulting in a higher tax rate. In general, consider the following asset locations:
Tax-free Roth accounts are a third tax wrapper. REITs or REIT index funds are perfect for this tax wrapper, because the dividends are taxed at higher rates and REITs also offer the opportunity for growth.
3. Tax diversification – I’m often asked which accounts I prefer – taxable, tax-deferred or tax-free wrappers. My answer is all three. None of us know what our tax rate will be in retirement, or what changes in tax law might occur.
Thus, using all three is a form of political diversification. If, for example, marginal tax rates increase, then the Roth would look attractive. If we move to a consumption tax like the fair-tax act, the client ends up paying taxes on the money when she contributes (giving up the deduction) and again when she spends the money. That scenario may sound far-fetched, but politics can be quite unpredictable.
4. Tax-loss harvesting – I tell clients who are fretting about portfolio losses, “I’m sorry for your loss, but make the most of it.”
QuoteI tell clients who are fretting about portfolio losses, “I’m sorry for your loss, but make the most of it.”
While typically only a $3,000 loss per year can be recognized, an unlimited amount can be carried forward and used to offset future gains. Be sure to watch out for the wash rules and avoid buying back the same security within 30 days.
This can be done without exiting stocks for a month by buying a similar fund. For example, you could replace a Vanguard Total Stock Index Fund ETF (VTI) with a Schwab U.S. Broad Market ETF (SCHB). Both follow different U.S. total stock indexes.
5. Withdrawal strategies – When your client retires, tax strategy continues to be critical. Generally speaking, the client should spend taxable assets first, tax-deferred assets second and Roth assets last.
However, the client often has an opportunity to pay taxes sooner at a lower marginal rate. If, for example, the client is retired before age 70 but elects to delay Social Security until age 70, the client’s income may be very low, leading to a lower marginal tax rate.
This creates an opportunity to take funds out of the traditional IRA/401(k) wrapper sooner, with a lower tax rate, rather than later, when the client is taking social security and must take the RMD, leading to a higher tax rate.
Two ways of taking money out are making a simple withdrawal into a taxable account and converting some to a Roth. Finally, during the time income is low, the client may be able to recognize long-term capital gains at a zero percent tax rate.
6. Multiple Roth conversions with a put to recharacterize – One way to get more money into the Roth tax wrapper is to convert traditional tax-deferred money to Roths. Every year, I do several Roth conversions and put each one in a separate asset class.
If I do the conversions in early January, I have over 22 months during which I can undo the conversion, in what’s called a recharactization.
I explain to clients that a traditional IRA/401(k) is really jointly owned by themselves and the federal and state governments. If the client is in the 30% marginal tax bracket (federal and state), they own 70%, and a conversion is buying the government’s share out.
Thus, for example, if they convert three IRAs and one is in a REIT index fund that loses 37% of its value (as it did in 2008), recharacterizing essentially makes the government buy back its share at the original price.
Many states also have a pension exemption so some of the conversions can be state-income-tax free.
7. Using HSAs to get both a deduction and tax-free growth – If your client has a high-deductible health plan that qualifies for an HSA, they get a tax deduction in the year they contribute. This gets them the same benefit as a traditional IRA. But rather than reimburse themselves for out-of-pocket health care expenses, clients can pay with taxable dollars and keep a tab on expenditures.
This means they can reimburse themselves at any time, even decades later. They can also use these funds to pay Medicare premiums and long-term care premiums and expenses.
8. Use muni bond funds to get tax losses without economic losses – Interest rates have declined and muni-bond coupon payments are higher than the SEC yield. The SEC yield represents the fund’s true income and carves out any return of capital that is included in the distribution yield.
The Vanguard Long-Term Tax-Exempt Admiral fund (VWLUX) has an SEC yield of 2.37% as of October 26. Though this is the true income, the total distribution yield is 3.49%, meaning roughly 1.12 percentage points is return of principal from an economic perspective.
If this continued for a year, an estimated loss of the net asset value of 1.12 percentage points could occur. You can then have your client recognize this loss, even though they actually received the 1.12 percentage points via a tax-free coupon payment. The fund must be held for six months or the losses could be disallowed, according to IRS rules. 852(b)(4)(B).
QuoteImplementing these strategies can be worth a bundle to clients.
Implementing these strategies can be worth a bundle to clients. If done right, clients will make more money after taxes, often while actually lowering risk.
Certainly they will love being told they can get both a tax deduction and tax-free growth, or that they can get a tax loss without an economic loss.
Because these strategies are not simple to implement, they represent the kind of value-add that robo advisors can’t compete with. If you’re not very familiar with tax law, consider involving the client’s tax accountant.
By partnering with other professionals on a client’s team, you can build trust among all parties.