Podium buzz and hallway chats at the recent Tiburon CEO Summit were all about reducing client taxes. One remedy I heard over and over was tax harvesting. It led me to wonder whether tax harvesting is like an abacus in a world operating on algorithms.
So I asked my colleague, Martin Cowley. For the past 25 years, he has been one of our industry’s most innovative thinkers and builders of advanced technology that empowers the world’s largest financial institutions to deliver tax alpha for clients.
His take on tax harvesting? Useful, yes, but it’s only one operation in a continuous process of limiting investment tax exposure and producing better — as much as 33% better — outcomes for clients.
Taxes are investors’ highest cost. It’s tricky, though, to evaluate what investor activities — buys, sales, trades, transitions, new accounts, product purchases — mean in terms of taxes today, tomorrow and even years later.
“We know from experience that comprehensive advice platforms, like those our clients are building, can automate and personalize financial advice to a degree that was unimaginable just 10 years ago,” Martin said.
He zeroed in on five practices that can achieve tax alpha. Each produces value; but together, they’re a powerhouse.
Nothing is as powerful as asset location in reducing taxes for investors, Martin said.
Asset location describes selecting suitable investments, based on their tax treatment, for different types of accounts that will result in the lowest possible tax liability. A Vanguard paper said asset location can improve results by up to 75 basis points.
“Spreadsheets can’t come close to the efficiency and accuracy of asset location when it’s done with the benefit of technology,” Martin said. Platforms that can perform complex algorithms to evaluate a portfolio’s tax efficiency can suggest how to reallocate investments across different accounts to improve tax efficiency.
Indeed, using asset location should reduce the need for the following key to tax alpha: tax harvesting.
It’s a ritual: Each year in the last quarter, portfolio managers field calls from clients and their accountants to find out how to offset gains by selling some assets at a loss.
The weaknesses of tax harvesting are: it tends to be reactive; can pull investors away from their target allocations; and, like market timing, presents the risk of harvesting gains or losses only to have the market take an unforeseen swing.
Ongoing, rather than seasonal, tax harvesting is wise, Martin said. A better approach is sensitive to clients’ marginal and capital tax rates as it uncovers opportunities for tax harvesting over multiple accounts in household portfolios.
“Then we can recommend down to the tax-lot level what to sell to realize the savings,” he said. “Of course, there are more opportunities for tax harvesting when recently purchased holdings drop in value. A more mature portfolio presents few, if any, losses, to harvest.”
When investors consolidate accounts, transitioning assets from one manager to another poses the challenge of selling assets and buying others to avoid paying unnecessary taxes. A transition can be a way to implement an asset location strategy that benefits a client, Martin noted. It’s also a way of rebalancing over time with controls to avoid unnecessary taxes.
Advisers ideally should manage an entire portfolio to a target allocation across all taxable and tax-advantaged accounts, even when the portfolio includes separately managed or unified managed accounts.
“We often see portfolios that contain a mixed bag of managed accounts and adviser-traded accounts. Managing and rebalancing such a hybrid portfolio is challenging — but possible — with software help,” Martin said. “With the larger pools of assets available in multi-account situations, advisers have more flexibility in lot selection and optimization through asset location.”
Integrating asset location, tax harvesting, transitions and rebalancing into comprehensive advice platforms will produce more retirement income for clients and more significant asset-based revenue for advisers and their firms.
Martin also observed other ways advisers can help clients:
1. Carefully time Roth conversions to balance short-term effects (tax bills) and long-term advantages (lower required minimum distributions). Asset location and Roth conversions can turbocharge each other.
2. Optimize Social Security benefits through a couple’s claiming strategy or, for individuals, deferring benefits until age 70. Investors can increase benefits over 10 years by as much as $150,000 by delaying.
3. Plan for taxes from RMDs. Retirees must take distributions from certain tax-advantaged accounts starting the year they turn 72. Asset location in the accumulation phase is critical here, with one eye on the future when clients’ RMD timer goes off.
Get taxes out of the way today so investors aren’t tripping over them in the future, Martin advises. “We write APIs that run algorithms to minimize taxes and test the value of any purchase, trade, or sale against the potential for future taxes. To us, that’s how you create tax alpha.”
Jack Sharry is executive vice president and chief growth officer at LifeYield. Martin Cowley is executive vice president and head of product at LifeYield.
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