Rob Arnott: How UMAs can help limit your tax tab
Tax cuts enacted in 2003 are about to expire. If they aren't extended past this year, the top capital gains tax rate will jump to 20%, and dividends will be taxed as regular income, with a top rate of 39.6%.
Tax cuts enacted in 2003 are about to expire. If they aren’t extended past this year, the top capital gains tax rate will jump to 20%, and dividends will be taxed as regular income, with a top rate of 39.6%.
Both rates now are set at a maximum of 15%.
This near-inevitable tax hike is perhaps only a down payment on the possibility of much larger taxes in the years ahead to pay for ever-larger entitlement programs and expanding government debt.
Unified managed accounts — a turbocharged form of separate accounts often aimed at high-net-worth investors — can help limit the tax tab.
A UMA’s overlay portfolio manager is in an ideal position to coordinate a variety of portfolio activities to reduce the bite of income and capital gains taxes levied on the portfolio.
The savings aren’t trivial. Some long-term UMA portfolio managers and several UMA program sponsors show composite annualized performance benefits (after tax, after fees) in excess of 1% annually.
But many UMA sponsors aren’t offering this advantage to their customers.
We find it alarming to leave 1% on the table — more than what most active managers deliver consistently — when tax-reducing methods are well-known, readily available and require only a modest operational investment.
UMAs were among the great financial innovations of the 1990s. An investor could have one master account, spanning an array of favorite investment managers and strategies, each with its own subportfolio.
The advantage: a new level of coordination and customization. UMAs offer huge benefits to all participants.
The investment managers deliver their model portfolios to an overlay portfolio manager, who is responsible for portfolio construction and re-balancing. This avoids the burden of investment managers’ having to run tens of thousands of smaller accounts themselves.
The investors can customize their portfolios. They can choose from a number of institutional-quality managers, most of whom wouldn’t consider managing such small accounts without a UMA.
The UMA vendors have a stronger hold on their adviser clients than ever before, with higher profit margins and an opportunity to position their brands alongside third-party money managers and mutual funds.
Yet even as UMAs grow and tax rate increases approach, most programs are ignoring the benefit of tax management. We understand part of the reason.
Many important legacy systems and industry business practices ignore taxes. In addition, helping customers reduce their tax bill won’t win points in Washington, even though tax management is perfectly legal.
Tax-advantaged methods for portfolio structuring, loss harvesting, after-tax reporting and the processes of overlay portfolio management are well-known.
Consider these examples:
• If an investor has one manager who is selling a stock for a short-term gain and another manager who has a long-term position in the same stock, why not swap the two tax lots and sell the long-term holding?
• If a manager holds a stock at a loss, particularly a short-term loss, why not sell all or part of it to realize the loss and create an “asset” that can offset a short-term gain now or in the future? This is called “loss harvesting,” which should be done carefully year-round, not just ad hoc as year-end approaches.
• If an investor has one manager who is buying shares of General Electric Co. and another selling the same stock at a loss, why incur a “wash sale” that removes a tax benefit?
• If an investor opens a UMA and deposits securities that have appreciated, why not incorporate those holdings into an appropriate subportfolio?
• If an investor wants to shift the overall portfolio manager and/or asset mix, why not choose the most tax-aware means of doing so?
A sensible tax overlay program can help both the UMA vendor and the end-client address every single one of these questions and more.
The after-tax potential of unified managed accounts represents a tremendous opportunity, especially as tax rates ratchet higher.
Increasing market share and client loyalty are exciting potential benefits for program sponsors who create and support UMA programs designed to help keep more money in their clients’ accounts and less in Uncle Sam’s.
Robert D. Arnott is chairman and founder of Research Affiliates LLC, an investment management firm. Brian Langstraat is chief executive of Parametric Portfolio Associates LLC, an investment adviser.
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