Uncle Sam Taking Your Wallet at Tax Time

Change is inevitable in investment portfolios as market conditions evolve and better solutions emerge. At the very least, asset allocations should change over time simply because the client is older and has a lower appetite for losses and less time to recover from them. Yet, a cursory glance of many client portfolios reveals how stagnant they have been for many years. It is important to ask yourself: Are your clients’ investment plans stuck in neutral?

A critical reason for this inertia is the tax implications of any transition from one portfolio to another. When one exits or sells an existing position, they are liable for taxes on any capital gains on that position, which are due in the year of the sale. This creates an immediate cost for any change in the portfolio, regardless of the economic driver of the change. The destination may indeed be a better allocation mix, or improved future downside protection, or a cheaper product mix — but these benefits are often weighed down by the ramifications of the immediate tax burden resulting in stagnant and paralyzed portfolios.

Advisors and their clients often resort to a status quo — but the costs are mounting.  We are now around a decade into a bull run with increased concerns about future downside risk. We owe these concerns to a whole host of factors dominated by the uncertainty of equity-bond correlations and the risk of decreased liquidity affecting prices of various asset categories. A decade is also a long time for such a run, in which one’s allocations should shift and reflect more stability and security.

Many advisors understand this, yet because of their clients’ anxiety about the future, still struggle to convince them that transitioning their portfolios is necessary. This challenge is human. Behavioral finance has documented our tendency to choose a smaller-sooner reward over a larger-later reward in a manner that is not entirely rational. Today’s pain often dominates tomorrow’s gain.

In addition to the immediacy of the tax-related costs, there is the additional issue of uncertainty that promotes the status quo. Transition-related tax costs due today are certain. Any benefits due to a better destination are uncertain. Finally, even as the increasing costs of stagnancy are brought to a client’s attention, these are offset by the increased capital gains on existing positions after a decade-long bull run in most asset classes.

In such a setting, what is an advisor to do?

Engage Optimization Tools

Advisors can use optimization tools to transition to their desired portfolios without incurring a tax liability. This may result in various levels of transition for different portfolios, but the resulting allocation will still be superior to the status quo. Although optimization is not as simple as selling all loss-making positions, the losses can be offset with the gains in ways that minimize portfolio distortion and maximize a larger transition. There are technologies available to advisors today that enable them to easily make these optimizations.

Set a Tax Budget

The advisor should present the problem as one of choosing a tax budget rather than a binary decision to switch or not. Once the client can see the possible costs of staying put, they might be willing to incur a small amount, say 25%, of the tax burden associated with a complete shift. In many portfolios, a small allowance can help shift a large portion. The ability for an advisor to present alternatives across different tax budgets can address some of the behavioral issues in the decision and be sensitive to client needs.

Minimize Portfolio Distortion

Before engaging a tax-optimized transition, the advisor will also need to carefully consider which positions from the existing portfolio are sold and which positions from the desired portfolio are indeed entered into or bought. Selling positions with a loss and buying the entire target portfolio will often distort the desired allocation. For example, if all the losses are from a given sector and an advisor sells only these, and they buy the overall equity exposure of the new portfolio, they will end up with a small allocation to the sector they exited. Again, the quality of the transition and ongoing monitoring can make a material difference to the client outcome.

There is an incredible opportunity today to fortify and adjust client portfolios — and transition taxes should not hold you back. Advisors who can present a strong and credible case to do this, and who have equipped their practice with an automated and intelligent tax transition solution, will not only be able to take their own clients out of neutral, but will have a competitive leg over other firms and win over new clients who feel stuck.


Dr. Vinay Nair is the founder and chairman of 55ip, a leading investment science and technology company. He brings nearly two decades of experience working with investment management professionals and academics. Nair is a visiting professor at The Wharton School and the MIT Sloan School of Management and serves as an advisor or board member to several companies that aim to utilize modern science and technology to solve real-world problems. He holds a Ph.D. in financial economics from the Stern School of Business at New York University.