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Tax optimization: The new frontier?

Soon after the launch of Fidelity’s zero-fee index funds, some advisors are turning their heads towards what may be the next frontier for increasing returns.

“I think the most obvious answer is tax optimization,” says Sean Slotterback, founder and chief executive of Decipher Finance in New York, which uses algorithms to make recommendations to advisors in regards to how client accounts can generate the best returns.

Returns can go up by whole percentage points when an individual reduces the effective tax rate by moving investments around to different accounts, he says.

Here is how it works: Move the investments with the highest return into accounts with no taxes, such as health savings accounts or Roth individual retirement accounts.

The catch?

The more accounts involved, the more complex it becomes, Slotterback says.

“Unfortunately, fitting the correct investments across 5, 10 or 15 accounts, for example, is akin to solving a giant Rubik's cube: Sure, you can get the basic idea, but an algorithm is the best and fastest way to solve the problem,” he says.

Slotterback thinks that computers are the answer.

Without using technology, 10 advisors would come up with 10 different solutions, he says.

Computers provide consistency and the most effective solution, as well as a paper trail of why the decisions were made in the first place, Slotterback says.

But computers aren’t sufficient standing alone; they work better as portfolios get more and more complex. In other words, they are more effective the more accounts the clients has opened and ideally, the more tax-advantaged accounts the client has opened.

This all falls back to the advisor and the recommendations he or she is making for clients.

“In general, the more that the financial planner is able to convert their wealth to tax-advantaged accounts, the more algorithms like Decipher can optimize those accounts and produce higher and higher returns,” Slotterback says.

But there are barriers. One is lack of education on the benefits.

Advisors have a fiduciary responsibility to their clients, but this means very little if an advisor is unaware of how it could help, Slotterback says.

Despite awareness difficulties, some of the financial services industry is starting to pay attention.

Morgan Stanley partnered with software company LifeYield near the end of 2017 in order to integrate its tax optimization capabilities into advisor software, according to LifeYield.

Decipher Finance, which launched its product last year, recently closed its first institutional deal with a Japan-based asset manager and is piloting to several firms in the United States.

Whether or not the company sees success, Slotterback says that the industry will continue to put more emphasis on how to most effectively optimize taxes.

“Computers will assume more and more of the problem,” he says. “And I think that’s better for all consumers.”

This story is part of a 30-30 series on tax-advantaged investing.

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