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Financial Planning > Tax Planning > Tax Loss Harvesting

4 Ways Not to Ruin Your Clients’ Taxes

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Investment advisor Less Antman knows more about taxes than your average experienced advisor. In fact, he knows more about taxes — far more, actually — than your average CPA.

The Fallbrook, Calif.-based RIA once offered to view the past several years’ tax returns of a new client and found buried within an item that materially affected the client’s wealth. He told the client to have her CPA file amended returns.

The CPA, a seasoned practitioner catering to high-end clients, drew a blank; his partner, particularly well known in the city, and also with decades of experience, also failed to grasp the opportunity.

Antman gave the client the relevant tax code citation and advised the client, who was eager to pay him to do the work, not to think any less of the two CPAs for their ignorance of a highly obscure tax provision.

The now inactive CPA spent 27 years teaching review courses for would-be California CPAs, giving him a uniquely deep knowledge of the tax code’s quirks. He also spent lots of time reading about taxes and tax planning ideas, but very little actually preparing returns and giving tax advice to clients.

Regarding the obscure provision he identified, he told the client, “I know these things because I’m not doing tax returns all day,” citing as a relevant comparison Dr. Dean Edell’s encyclopedic knowledge of the medical issues that callers to his now-defunct national radio program posed.

Today that tax knowledge comes in handy since, through tax-loss harvesting and the use of margin, Antman is able to save some clients as much as $100,000 a year through the effective tax management of their investment accounts.

Of course, such high savings imply large accounts, and indeed, the founder of financial planning and asset management firm SimplyRich counts several decamillionaires among his high-net-worth clientele.

But he also serves, as a favor to friends and family, some middle-class clients as well, and thus can offer perspective as to what advisors need to know and don’t need to know about taxes.

By and large, and perhaps to the relief of many, “except for advisors who work with high-net-worth clients or those who are dealing with stock options; [advisors] don’t really need to know much of anything about taxes,” he tells ThinkAdvisor in a phone interview.

Moreover, Antman adds that “a little knowledge can be a dangerous thing” and discourages a tax focus for advisors to the middle class.

The reason: “Most people lose more money trying to reduce taxes than they save in taxes,” he says. “This is why they end up going into annuities or municipal bonds or maintaining concentrated positions that are dangerous rather than diversifying and paying taxes.”

The taxation expert says that advisors must “realize that they don’t actually understand the tax code. Nobody does,” he modestly offers. “And if they get to the point that they understand it, they’re just going to change it again,” he jokes.

With those caveats in mind, here are four ways advisors can truly help their clients — from the superwealthy to the middle class — with taxes. Sometimes, it’s what you don’t overdo that helps clients most.

Bypass (Trust) Surgery

1. Beware the Bypass Trust

That propensity to make tax-driven bad decisions leads to Antman’s first key practical takeaway for investment advisors: They should ask their clients if they have a bypass trust (also known as a credit shelter trust), then advise them to discuss with their estate planning attorney whether to get rid of it.

“I know several people who designed bypass trusts in order to minimize estate taxes in the ’90s back when the lifetime exclusion was around $600,000 per person,” he says.

“Now it’s over $5 million per person, and a lot of people who carefully planned their bypass trust have lost the stepped-up basis on the death of the second spouse because they have assets in the bypass trust that won’t be exposed to estate taxes but [now also] won’t get the reset tax basis because they’re in that trust.”

In other words, few wealthy couples expected just a little over a decade ago that they’d be able to pass $10 million to their heirs free of federal estate taxes after the death of the surviving spouse based on an altogether new “portability” rule.

Portability allows the surviving spouse to transfer the unused portion of the deceased spouse’s exemption, and then upon the surviving spouse’s death, the heirs get a stepped-up basis shielding them from tax up to today’s generous exemption.

In short, “a bypass trust now often causes tax harm,” Antman says. He does note that there are other reasons bypass trusts are used that may still be relevant, such as protecting the children from a first marriage, and reminds advisors to merely suggest that clients discuss the matter with their estate attorney. Although many bypass trusts will, in fact, raise taxes on a client’s heirs unnecessarily, not all bypass trusts are useless.

Don't Rebalance Too Much

2. Don’t Rebalance Too Much

A second key takeaway that applies to most advisors:

“Keep tax planning simple,” Antman says.

“In taxable accounts, maximize equities to take advantage of deferral of unrealized gains and favorable rates when gains are realized, and use index funds or funds that minimize the turnover of profitable positions. ETFs are particularly tax-friendly because sales are often executed through nontaxable transfers of positions with other ETFs or large institutional investors. As far as possible, keep real estate investment trusts, interest-bearing investments and high-turnover funds sheltered. When rebalancing, first change the investments in sheltered accounts or by recommending the client change their 401(k) allocations, and only rebalance in taxable accounts with new money or the proceeds of dividend distributions.”

Rebalancing is generally portrayed as some sort of best practice, but it has tax consequences that could be harmful. In fact, Antman elects not to have dividends automatically reinvested in taxable client accounts, though that’s also somehow thought of as a best practice.

“I always have it paid in cash so I can do some rebalancing without further tax consequences,” he says.

Antman offers other simple, but this time also uncontroversial guidelines for advisors:

“In high earnings years, they should maximize tax-deductible retirement contributions; in low earnings years, they should maximize Roth contributions; in no earnings years they should maximize Roth conversions,” he says.

Another key point now that clients have taxes on their minds: Advisors should advise them to plan on providing their tax returns on Nov. 1 for tax planning meetings in November and December. That’s when tax planning is done, he says, noting that the only really big things that can be done now for 2013 taxes are to open a SEP IRA if the client doesn’t have one or to do a Roth recharacterization if the client converted too much in 2013.

Tax-Loss Harvesting

3. Don’t Get Hung Up on Tax-Loss Harvesting

One other area — and a topic du jour — that advisors have less to worry about than they might think is tax-loss harvesting.

This is currently a hot topic given robo-advisor Wealthfront’s claim to save its clients more than 1% a year through its automated tax-loss harvesting.

“Traditional tax harvesting is less useful than it appears, and truly effective tax harvesting is harder than it looks,” the tax-savvy advisor says, citing approvingly Michael Kitces’ recent takedown of Wealthfront’s tax alpha claims.

“The truth is tax harvesting is of very limited value to [Wealthfront’s] client; it works in the first major bear market after the client has put money in the market but almost  never thereafter,” he says. “There’s a big bear market in one of the funds you own, you sell the position, buy it back or something similar without violating the wash sale rule, and now have a new position with a tax basis so low you are unlikely to ever be able to harvest that position again. And then rebalancing or the need to sell for spending money brings bigger gains onto your tax return later. Much ado about very little.”

Advisors to middle-class investors should simply invest assets in globally diversified index funds or ETFs and not worry about taxes until the client is independently wealthy.

For those who have achieved that comfortable status, an advisor can save on taxes through a process of investing in individual stocks — making sure the portfolio is adequately diversified — and using margin, with caution, to extend the period of harvesting benefits indefinitely into the future, using the equity created from bull markets to buy new positions that may generate additional tax losses. 

“Needless to say, this takes a lot of special attention, to ensure the individual stock portfolio is well-diversified, to obtain favorable margin rates (easy for wealthy clients but not for the middle class), and to be alert to the impact of bear markets on leveraged positions.

“I’ve saved one client over $1 million so far by harvesting $3 million in tax-loss deductions to use against his enormously profitable holding in one company, and we aren’t done. But before we began harvesting I demanded he sell enough stock, paying the full tax freight, to be independently wealthy. We didn’t start worrying about taxes until he could afford the risk of holding his remaining stock in the company long enough to generate the benefits,” he says.

It’s complicated stuff, and Antman says advisors should not feel an inferiority complex if they don’t understand it.

“Unless you have a stable of multimillionaire clients (Antman’s average account size is $3 million), learning how to do this will be as useful to your clients as learning how to speak Klingon. In the meantime, there are millions of people you can help dramatically just by being an ethical advisor who puts them into a well-diversified portfolio, makes sure they don’t change it during every fad or crisis, and keeps them from trying stupid things in the name of saving taxes.”

Optimize Social Security Timing

4. Optimize Social Security Timing

Antman did close with one more tax thought for the middle-class client, though, where he believes an advisor might help: Social Security. Antman says delaying taking benefits can have significant tax advantages, apart from the increased benefits that delay affords.

“People can lose $100,000 or more in lifetime benefits from a bad choice, and one of the worst is starting the payments early. So it is useful if you can add a tax reason for them to delay.”

Most advisors should avail themselves of one of the many Social Security analyzers available on the web, while retirement specialists should purchase software, Antman says. They are quite inexpensive and will almost always encourage at least one spouse to delay the start of benefits. Then add a kicker. 

“You can take advantage of a low-income year to do Roth conversions and convert income that would have been taxed at 25% or higher to 15% or lower,” he advises.

“I sometimes encourage clients who are between jobs to see if they can take some advantage of short-term unemployment by cutting their long-term tax bill significantly. But since up to 85% of Social Security is taxable when there is significant other income, you’ll also be able to do much more converting at low tax rates in the early years of retirement if you haven’t started Social Security yet.

“The analyzers, which will usually be encouraging delay, typically don’t even take this benefit into account, and you may just add $10,000 to a middle-class client’s net worth with one simple suggestion,” he says,  “which is a bigger benefit than they’ve probably gotten from all the tax schemes they’ve tried in their entire life.”

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