From the February 2011 issue of Investment Advisor • Subscribe!

Dispatches from the Tax-Efficient Frontier

Three advisors share views on the power of tax deferral

Congress has passed a measure to postpone income tax increases for at least two more years, but, inevitably, most experts predict lawmakers will be forced to raise taxes to help cut the immense federal debt. When those tax hikes occur, your high-net-worth clients will likely be hit the hardest. With so many unknowns, it can be challenging to help them prepare. But there is one very simple and effective strategy that you can use to help clients reduce their tax bill now.

New research shows that tax deferral can potentially increase returns on tax-inefficient assets by as much as 100 bps—without any subsequent increase in risk—simply by locating assets based on their tax treatment between taxable and tax-deferred vehicles. This is the domain of the “Tax-Efficient Frontier.”

Tax-efficient assets, such as index funds and passively managed funds, generate long-term capital gains and dividends, currently taxed at rates of 15% or less. Tax-inefficient assets, including bond funds, REITs and many hedge-like funds, generate ordinary income or short-term capital gains, currently taxed at rates as high as 35%. Actively managed investments can suffer the biggest hit—short-term capital gains tax plus the added cost of multiple transaction fees.

A textbook asset location strategy would put all tax-efficient asset classes in taxable vehicles, and all tax-inefficient asset classes in tax-deferred vehicles. In the real world, however, U.S. tax law places restrictions on contributions to tax-deferred qualified accounts. This can be a major hurdle for highly compensated individuals. In 2010, 401(k) plan limits were $16,500, and IRA limits were $5,000 ($6,000 for individuals 50 or older).

So how can you help your clients—especially the high-net-worth—make the move to the Tax-Efficient Frontier? We talked with three different advisors to get their take on implementing this simple, but effective, strategy.

Take Diversification to the Next Level
“A quality advisor recognizes that tax-deferral is crucial—I don’t know of anyone who couldn’t benefit from it in some way,” says John Ritter, CFP, CFS, founding partner and lead financial advisor of Cincinnati-based Ritter Daniher Financial Advisory LLC, a firm with roughly $200 million under management.

Managing the complexities of long-term planning, and the responsibilities of providing prudent advice, Ritter believes it’s important to have a handle on every part of the financial picture—including taxes. “Clients could take a big hit if taxation isn’t in balance,” he says. “We try to talk about it at a high level, not at a tax code level. ‘What’s the best way for us to position these assets so we’re either minimizing your taxes or so that more of the income flows to you?’ When we put it in those terms, most clients can easily follow along.”

Ritter helps clients reach the Tax-Efficient Frontier by taking diversification to the next level, placing assets into different “buckets”—taxable and tax-deferred. “Our goal is to be as diversified as possible, considering the tax implications of an asset and making sure it ends up in the right bucket. From this perspective, there are many cases where tax-deferral simply makes the most sense,” Ritter says. In recent years, Ritter Daniher has done this kind of asset location work with about a quarter of its clients. “It wouldn’t surprise me if that moves to 50% or even north of 50%,” Ritter says, especially when tax hikes start to take place.

Manage Taxes on Tactical Strategies
In response to today’s volatile markets, recent data suggests that many advisors are eschewing buy-and-hold strategies and adopting a more tactical approach. In a survey of advisors at Jefferson National, we collected more than 1,000 responses indicating that two-thirds of advisors are feeling pressure to revise their investment strategy and they are now more confident in tactical management than buy-and-hold.

These findings resonate with Brian Schreiner, vice president and head of Advisor Services for Schreiner Capital Management Inc. Schreiner believes that saving for retirement, like all important goals in life, requires an active approach. The basic building blocks of good investing won’t change—establish a goal, create a plan, be disciplined and don’t overreact. “But with a passive strategy you’re just holding on to the market with all its ups and downs,” says Schreiner. “In the crash of 2008, we saw the market drop over 50% and there’s a very real possibility there could be more losses before we see a recovery. Should your clients really take a passive approach to this kind of risk? We think there may be a better way.”

Schreiner takes an active approach, which will generate some short-term capital gains for clients, but as he says, “If we can manage risk and preserve capital, for risk-averse investors, the tax bill is secondary.” Still, there’s no doubt that minimizing taxes on tactical strategies can bring greater benefit to clients and enhance their portfolio’s performance. That’s when the Tax-Efficient Frontier comes into play. Research confirms that tax-inefficient assets such as actively managed investments that generate short-term capital gains consistently perform better in a tax-deferred vehicle.

But Schreiner has always found tax-deferral options limited, especially for his high-net-worth clients. “Once an investor maxes out their 401(k), IRA and Roth, if they still have long-term funds to invest, there aren’t many advantageous solutions.” Schreiner believes these are the ideal clients for using a low-cost, no-load variable annuity to achieve the Tax-Efficient Frontier. “They appreciate the benefits of tax deferral—and the substantial savings in fees. They don’t need riders—they need the tax shelter. They want their income to compound and grow.”

Benefits for Bonds
When it comes to helping clients maximize returns to generate 30 or more years worth of retirement income, many advisors seek solutions to beat the market with minimal risk. Lexington, Mass.-based BTS Asset Management, an RIA with nearly $2 billion in assets under management, over 15,000 individual and corporate accounts, and partnerships with more than 3,000 financial planners nationwide, has been providing such solutions for clients and for other advisors since launching in 1979.

There’s a credibility earned by being one of the oldest third-party money managers in the industry. “With three decades of experience, we’ve been through a lot of different markets and economic situations—bull and bear, recession and recovery,” says Isaac Braley, president of BTS. “We do it using bonds—and that does not receive any special tax treatment. Our portfolios are tactical—meaning 100% of returns most likely are going to be taxed at ordinary income. So, a tax-deferred compounding vehicle is an unbelievable tool for us,” says Braley.

From Braley’s perspective, The Tax-Efficient Frontier is the right fit for BTS’ fixed income strategy. “We have historically outperformed the market and have demonstrated the potential to enhance returns. And when we can use a tax-deferred vehicle to wrap it up, let the gains grow and only pay taxes on the money when clients need it, it enhances the performance potential in a meaningful way,” Braley says.

A Simple—but Effective—Strategy
Do clients understand the intricacies of the Tax-Efficient Frontier? Not always. But there are simple steps you can take to help guide them through the asset location decision. It can be useful to maintain a grid where all of the available asset classes are arranged in order, by tax efficiency and potential return based on time horizon, so clients can clearly see when and where tax-deferral can offer the greatest benefits. It is also helpful to review clients’ holdings in their taxable and tax-deferred accounts. If the allocations and underlying holdings are essentially mirror images of each other—rather than being located based on tax-efficiency—your client may be missing an opportunity to improve performance without any increase in risk.

Of course, an asset location strategy only makes sense with clients who have both taxable and tax-exempt assets. If clients have everything in a tax-deferred account, the asset location question is moot. But once you start to have a relatively good mix between taxable and tax-deferred vehicles—at least 80-20 one way or the other—that’s when clients start to see the real benefits of the Tax-Efficient Frontier.

Trends clearly indicate that there will be a greater demand for a holistic approach to financial advice—and with that will come a greater tax awareness added to portfolio construction. Using tax-deferral strategies to unlock the potential for greater performance can help clients complete their long-term investing strategy and reach their goals faster. In an environment like today’s, where every single basis point of performance counts, tax deferral will rise in importance and the Tax-Efficient Frontier will emerge as an important new financial landmark.    

David Lau is chief operating officer of Jefferson National, innovators of the first flat-insurance fee variable annuity with the industry’s largest supermarket of tax-deferred funds. He is also author of recently published white paper “The Tax-Efficient Frontier: Improving the Efficient Frontier with the Power of Tax Deferral.” To download a copy of his latest research, visit For more information, call 1-866-WHY-FLAT (866-949-3528).

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