3 Ways to Help Clients Create Tax-Efficient Portfolios

Before 2022, investors had been enjoying a lengthy bull market interspersed with brief equity market downturns. This left many investors sitting on unrealized capital gains — and based on our conversations with financial advisors, the thought of having to pay taxes associated with realizing capital gains they accumulate from their equity investments can often prevent them from taking proactive steps to diversify and mitigate risk in their portfolios.

The severe market volatility that emerged last year caused investors to rethink their asset allocations and revisit concentrated positions they held. And on top of that, the Federal Reserve’s gradual, ongoing increases in interest rates have made forward-looking returns for fixed income and other non-equity asset classes appear more attractive.

These two developments provide advisors with an opportunity to demonstrate their value for clients, by working with them to make decisions on how to best decrease risk in their portfolios. The market volatility and the losses it created enable advisors to help clients reconsider asset allocation and concentrated positions, and make portfolio adjustments in a tax-efficient manner — and the potential generation of tax savings over the long term can further elevate the advisor-client relationship.

Below are three ways for advisors to help clients position their portfolios to weather market volatility and harness tax efficiencies:

1. Make Tax Management Relevant All Year Long

Too often, investors wait until the end of the year to think about taxes. But taxes shouldn’t only be top of mind before and during tax season. Effective tax management has a year-round outlook. One of the best ways to condition clients to think about the tax benefits of asset allocations and financial decisions is for advisors to create a capital gains budget for clients using technology overlay solutions. These tools can show clients what effects potential changes to their investment portfolios could have on their tax bills that year.

Also, by harvesting losses to offset gains that have been realized, advisors can often demonstrate value to clients by ensuring that the overall gains realized in their investments do not exceed their capital gains budgets. This provides clarity to investors as to what their tax bills might be the following year so that they plan accordingly.

2. Show Clients a Holistic View of Their Accounts

Unified managed accounts can be a particularly beneficial account structure to enable advisors to obtain a holistic view of their client’s investments from a tax standpoint. By including all of their investment strategies in one account, advisors are able to see a 360-degree picture of a client’s overall investment portfolio in one place and coordinate gain and loss realization across the various strategies.

They can also deliver urgent, and comprehensive, tax insights that can be presented in discussions and meetings. For example, an advisor can review all of a client’s investment strategies, and come to the client and say: “These were all of the capital gains you realized last year according to the budget you provided us — is this more or less than you would like it to be?” Then, the advisor can show the client what needs to be done, across their accounts, to reduce or increase their total capital-gains realization.

The advisor can also ask, “Do you have gains realized elsewhere that we should talk about when thinking about what your tax exposure will be next year?” This is a great lead-in to discussions about the client’s financial assets that are not overseen by the advisor — and how the advisor can add value in those areas, and perhaps bring those assets in and increase wallet share.

3. Eliminate Short-Term Capital Gains

Long-term capital gains — capital gains on assets held for more than a year — are taxed as dividend income at preferential rates (typically no more than 20%). Short-term capital gains, on the other hand, are taxed at an investor’s marginal income tax rate, which is typically 37% for high-net-worth investors.

In other words, when an investor realizes a short-term capital gain, they are taxed at nearly twice the rate as when they realize a long-term capital gain. And, on top of that, when adding in state income taxes, the total marginal income tax rate in some U.S. states can be north of 50%. This is why one of the most important benefits an advisor can provide from a tax management perspective is the reduction or elimination of short-term capital gains.

Utilizing a holistic view and outlook with regard to a client’s investments, an advisor can obtain a comprehensive understanding of what a client’s long-term capital gain realization should be, in accordance with a client’s financial needs, goals and risk tolerance — and how short-term capital gains can be reduced across a client’s accounts.

It has been said that you learn who your true friends are in a crisis. Similarly, investors can learn the true value of their advisors during stormy market conditions. The present economic climate gives advisors the opportunity to help clients reflect on how they can adapt their investments to reduce risk and protect their portfolios.

Advisors can demonstrate their value by showing investors that they don’t need to let their distaste for paying capital gains taxes prevent them from taking steps to de-risk their portfolios. Helping clients understand how to make investment and financial decisions that generate tax efficiencies across their accounts can only strengthen the advisor-client relationship over the long term.

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Erik Preus, CFA, is managing director of Envestnet PMC, Envestnet’s portfolio consulting group.