Few would debate that 2020 has been a challenging year, and one wrought with uncertainty. This year in particular, clients are likely to welcome a helping hand as they take stock of their finances, and there is a significant opportunity for advisors to introduce more certainty to their tax planning process. Said clients will likely be grateful for the guidance, too: a recent study showed that, while investment selection and asset allocation are the primary factors impacting portfolio returns, tax liabilities aren't too far behind.
What is tax-aware investment management?
Tax-aware investment management, also known as active tax management, is the practice of considering your client’s tax liabilities throughout the portfolio construction process to proactively maximize their after-tax returns. It can be particularly valuable for high-net-worth investors, given their oftentimes complex financial situations and propensity to be taxed at higher rates than their less-endowed peers. In fact, in a 2016 U.S. Trust survey of high-net-worth individuals, more than half of respondents indicated they placed greater emphasis on minimizing tax burden during the investment decision-making process than they did simply pursuing high returns without regard for the tax consequences.
As an advisor, it’s your fiduciary duty to make sure you’re always acting in your clients’ best interest and helping them to advance their financial goals. Yet in the absence of a thoughtful tax strategy, high-net-worth investors may find themselves facing higher-than-necessary tax bills, and their investment returns could be affected in the longer term. With that in mind, as we approach the end of the year and focus on planning for 2021, it might be a good time to review your clients’ portfolios and consider whether their current strategies are optimized to reflect their unique tax situations.
SMAs for tax-aware investment management
At Ethic, we use separately managed accounts (SMAs) to create returns-driven, low-cost, tax-efficient sustainable portfolios that align with your overall portfolio allocation strategy. SMAs are differentiated in that their holdings can be flexible, tax-optimized and personalized to reflect the individual’s values and risk appetite—all while maintaining a low tracking error against the given benchmark. Crucially, because SMA investors actually own the individual equities in the underlying portfolio, they are able to offset capital gains through the sale of investments that will produce a capital loss. Unlike with mutual funds, they’re also not beholden to embedded capital gains, in which all fund investors share the tax liability for capital gains made each year—even if they only bought into the fund in December, and haven’t enjoyed any of those profits!
What does tax-aware investment management entail?
Ethic’s sustainable, passive equity portfolios make it easier for advisors to help their clients navigate the potential tax implications of a new investment strategy, engage in continuous tax management, and conduct tax-efficient withdrawals. Here’s a quick overview:
An important part of any advisor’s toolbox, tax-loss harvesting is the process of selling an investment that has declined in value in order to offset taxable gains in a portfolio. When implementing this strategy, it’s important to be mindful of the IRS ‘wash sale’ rule, which prohibits investors (and their spouses) from repurchasing the investment they just sold—or one that’s considered “substantially identical”—for at least 30 days. Ethic helps you to seamlessly navigate these considerations while minimizing tracking error against underlying benchmarks.
Some clients may wish to transition their portfolio to one that better aligns their personal values with their financial goals, but there can be tax considerations associated with liquidating a portfolio that has already accrued significant gains. Our direct indexing approach allows advisors to gradually transition a client’s positions over time, while identifying any overlap in holdings and determining the amount of taxable gains the client can absorb without deviating too far from benchmark exposure.
Clients will likely wish to tap into the gains generated by their portfolios, particularly as they approach retirement. However, in the case of realized gain (i.e., when an asset’s sale price exceeds its original purchase price), there can be significant tax implications. You can help your clients to preserve their nest egg by establishing and maintaining a realized gain budget that can shield them from unnecessary tax surprises.
The role of the advisor has expanded over the years, and now entails much more than simply generating returns on investment. Clients may look to you for guidance when it comes to planning some of life’s biggest decisions, staying the course during emotionally charged times, ensuring that their personal values are reflected in their portfolios, and establishing their legacy for future generations. Don’t miss an opportunity to also demonstrate your value when it comes to helping clients successfully navigate the complexities of existing tax code and make sure they’re not leaving money on the table unnecessarily. The time you take to familiarize yourself with tax-efficient direct indexing strategies could ultimately pay dividends in the form of more rewarding relationships with clients, who will almost certainly appreciate your proactive and personalized approach.