More On Tax Planningfrom The Advisor's Professional Library
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- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
With the Bush tax cuts set to expire at the end of this year, advisors need a plan for actively managing Uncle Sam’s upcoming bills for high-net-worth investors. One strategy to consider: index-based, separately managed accounts.
There are two methods for trying to save investors tax liabilities, and both often fail to generate enough alpha. First, there are actively managed separately managed accounts, which entail the hiring of an active stock picker. Secondly, there are straight indexers—portfolio managers who buy low-cost exchange-traded funds.
Neither of these approaches quite lives up to their full tax-advantaged promises. Although active SMAs are supposed to be tax-managed, doing so in addition to stock-picking is far too costly on an operational basis. That’s why most active SMA managers implement a set investment strategy with minimum customization in terms of tax efficiency. On the opposite end of the spectrum, straight-indexers seek to track benchmarks rather than beat them. Although they save investors money in terms of fund management fees and embedded capital gains, they aren’t generating tax alpha per se.
Index-based SMAs can offer the best of both worlds. Low-cost index portfolios provide beta returns, and active tax management provides alpha. Unlike an active manager’s strong desire to own specific “picks,” the index manager’s unemotional, agnostic approach to security selection is key to tax management.
Consider this typical scenario: An investor moves his portfolio to a new advisor, who recommends selling all of the client’s existing holdings and placing the assets into the advisor’s “picks.” Before the investor can say “boo,” the new advisor says, “By the way, here is a tax bill for the capital gains you realized when selling out of your old holdings. Welcome to our firm.” Not only does this relationship start on a sour note, but there is no guarantee it will pay off in returns. Research shows that active portfolio management is unlikely to outperform a low-cost, tax-efficient, index-based investment approach net of fees, costs and—yes—taxes.
Now consider an advisor using a tax-managed approach. Rather than sell off all holdings immediately, the securities-agnostic advisor can retain many of the holdings in the index portfolio and avoid realizing unnecessary gains. For example, the index portfolio will likely need to own large-cap information technology growth stocks. If the client already owns Oracle at a low-cost basis, there is no reason to sell the stock and incur transaction and tax costs. Because the advisor uses SMAs, rather than ETFs, she can cherry pick what to keep or sell.
Indexed-based SMAs also provide ongoing tax management advantages, such as tax loss harvesting using a short-term capital loss to offset capital gains. If a California resident at the highest marginal tax rate (35% currently, 40% when the Bush tax cuts expire) invested $1 million and the advisor was able to harvest 6% in losses, the advisor has lowered his client’s tax bill by $24,000—hardly chump change. Advisors can achieve this in an indexed-based SMA because each account is managed for their client’s tax situation and the SMA can pass through capital losses, not just gains.
The caveat is that this level of service can be quite labor-intensive. It seldom makes sense for advisors to provide such custom, active tax management for accounts of less than $500,000 and for clients in the lower tax brackets. This level of service is only possible with an index-based approach.
Ultimately, taxes are an important, but controllable concern for individual investors. With tax rates predicted to go up, saving your clients both taxes and transaction costs is a way to offer convincing alpha—regardless of what the market, or Uncle Sam, does next.
Chief Investment Officer
Advisor Partners LLC