Given the run-up in stock prices over the past several years, many advisors have struggled with how they can reduce their clients’ equity exposure on assets outside of retirement plans while minimizing the tax impact typically triggered by these portfolio reallocations. Common strategies include tax-loss harvesting, making a charitable donation using appreciated stock, and a more complex strategy of using options to build an insurance overlay on the portfolio.
All of these strategies have one thing in common, though. They are attempting to solve a problem rather than avoiding it in the first place. Wouldn’t it be nice if there were a way to regularly rebalance a portfolio of stocks and bonds with minimal tax impact to keep the portfolio in line with the client’s risk tolerance?
Alternative Tactic: A Variable Annuity
Depending on the client’s circumstance, a variable annuity could be a viable solution.
Somewhere along the way, the financial industry began to think a variable annuity always had to be sold with a living benefit as a means to lock in a predetermined amount of retirement income. We seem to have forgotten that a variable annuity can be a great way to shelter portfolio gains from income taxes. Any decent variable annuity today will have a multitude of investment selections allowing clients to invest in domestic and foreign stock, fixed income funds, commodities, etc. Just as important, if you need to rebalance your clients’ portfolios — either because a client’s risk tolerance changes or the markets change — as long as the money stays in the annuity, any gains continue to be tax-deferred.
A Client Case Study
Let’s say that an advisor has a 70-year-old client who holds the majority of his assets with a non-qualified trust account. His previous advisor recommended the cookie cutter 40/60 portfolio expected for a client his age. Between his pension and Social Security, though, income is not a need for him. After reevaluating his objectives and risk tolerance, he and his current advisor agreed he could benefit from more equity exposure. However, his pensions, Social Security and investment income already were creating a fair amount of taxes for him, and they needed a solution that would not substantially add to his tax burden.
Therefore, the advisor sold about 20% of the client’s non-qualified fixed income portfolio to buy a variable annuity. While the sale of the fixed income investments triggered a taxable event, the goal was to set this part of his portfolio up to avoid triggering taxable events when rebalancing in the future. With the variable annuity, the advisor chose to invest the client’s money in a real estate fund, a multi-strategy fund, an oil and gas fund, and a science and technology fund, in addition to an equity index fund, to provide portfolio diversification — all of these funds within a single product.
Two years later, driven by the steady rise in the market, the total investment grew to almost 30%. Given the growth in the variable annuity as well as other equity holdings, the client started getting a bit nervous about how much money he had in the stock market. His inquiries about market corrections became much more frequent. Clearly, it was time to take some equity risk off the table. But where to start? How could the advisor rebalance without creating taxes?
He could start with the variable annuity. After all, the advisor purchased the variable annuity to avoid taxable events when rebalancing. The advisor kept the investments in the variable annuity in the real estate, oil and gas, and the multi-strategy funds, but moved the rest to a fixed income allocation. With the goal of creating a 50/50 mix in the client’s portfolio, the advisor coupled the rebalance in the variable annuity with a rebalance in his traditional IRA by moving equity allocations to fixed income allocations. Because this client was a “pensioner,” the size of this IRA account paled in comparison to his non-qualified account, but the reallocation within the IRA, combined with the reallocation within the variable annuity, allowed the advisor to get the client back to an overall 50/50 portfolio. While the relatively small IRA account assisted with tax-efficient rebalancing, the advisor would not have been able to rebalance without income taxes if his client didn’t own a variable annuity.
See If a Variable Annuity Is Right for Your Clients
As your clients come in and express concern about the taxes they will pay on their investment earnings this year — especially due to the required mutual fund distributions — remember a variable annuity could provide a solution to your clients. A variable annuity does not need to always have a living benefit and can provide a way to shelter gains from income taxes — in a way, an IRA outside an IRA. If clients have non-qualified assets they don’t need for income for a number of years, they could find a variable annuity to be an attractive alternative. Talk to your clients about creating a non-qualified, tax-deferred investment portfolio using a variable annuity if this solution is in line with their long-term objectives and risk tolerances.
Scott Stolz is Senior Vice President of Private Client Group Investment Products & Wealth, Retirement & Portfolio Solutions at Raymond James.
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