Taxes Are One Thing – Not The Only Thing

But if your client’s desire is to beat the fund benchmarks, and they’re able and willing to take on added risk, consider replicating a mutual fund with individual stocks in their portfolio. Provided they have the capital to duplicate the exposure of whatever you’re targeting, you can even replicate the indexes by owning all the individual stocks.

This is a technique known as separately managed accounts, or SMAs. The active management of individual stocks, while potentially resulting in higher fees compared to owning passive ETFs, helps us utilize ongoing tax loss harvesting for our clients to take advantage of volatility and the ever-changing equity market valuations.

It also means that their cost basis in a stock is the price they paid for it, not what the mutual fund paid for it. Think of a mutual fund that has owned Apple since 1990 and the embedded gains sitting in that fund they buy into. Should that mutual fund choose to sell Apple after the investor gets in, the investor will be responsible for the tax on that gain since 1990.

On the fixed income side, some investors (especially those in low tax brackets) may sacrifice the returns of higher-yielding bonds in favor of owning tax-free municipal bonds. Remember, it’s OK to pay a tax if your net after-tax return is going to be higher regardless. This is a common tax avoidance behavior we see in investor portfolios.

I’ve written before about the benefits of alternative investing. While many alternatives can be highly taxed, the benefits (such as diversification) can potentially outweigh those risks. In our case, we feel strongly about the value in private equity, real estate and private debt despite their tax exposure. And when the situation permits and justifies it, we will own those assets inside of retirement accounts or other tax-advantaged vehicles available to high-net-worth investors.

Tax Rates for High-Net-Worth Individuals Are Lower Than Before

Remember the Tax Cuts and Jobs Act? Seems like a lifetime ago when it was signed in December 2017, but the first tax filings that will reflect the legislative changes have finally come around.

On top of reducing the marginal tax rate for the highest bracket from 39.5% to 37%, the act also doubled the gift, estate and generation-skipping transfer tax exemptions from $5.6 million to $11.2 million ($22.4 million for married couples). That new rate will apply until 2026, at which point it will revert to the prior rate, adjusted for inflation.

Planning for taxes is a wise decision every investor should undertake. Just remember that paying taxes isn’t always a bad thing; so, focus your client’s attention on after-tax return and take advantage of tax efficient structures when available.

Aaron Hodari, CFP, CIMA, is a managing director at Schechter, a boutique, third-generation wealth advisory and financial services firm located in Birmingham, Michigan.