3 ways to help clients build tax-efficient portfolios
The potential generation of tax savings in the long run can improve the advisor-client relationship.
Prior to 2022, investors had experienced a long bull market interspersed with brief downturns in stock markets. This has left many investors with unrealized capital gains – and according to our conversations with financial advisors, the thought of having to pay taxes associated with realizing capital gains they accrue from their stock investments can often discourage them from taking proactive steps to diversify and to undertake risk mitigation in their portfolios.
The severe market volatility experienced last year caused investors to reassess their asset allocation and reconsider concentrated positions they were holding. Moreover, the US Federal Reserve’s gradual, sustained rate hikes have made forward-looking yields more attractive for fixed income and other non-equity asset classes.
Both of these developments provide advisors with an opportunity to demonstrate their value to clients by working with them to make decisions about how best to de-risk their portfolios. Market volatility and the losses it causes allow 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 improve the advisor-client relationship.
Here are three ways advisors can help clients position their portfolios to weather market volatility and take advantage of tax efficiencies:
1. Make tax management relevant all year round
Too often investors wait until the end of the year to think about taxes. But taxes shouldn’t just be a priority before and during tax season. Effective tax management has a year-round perspective. One of the best ways to get clients thinking about the tax benefits of asset allocations and financial decisions is for advisors to create a client capital gains budget using technology overlay solutions. These tools can show clients how potential changes to their investment portfolios could impact their tax bills this year.
By offsetting losses to offset realized gains, advisors can often demonstrate value to clients by ensuring that total gains realized on their investments do not exceed their capital gains budget. This gives investors clarity on what their tax bills might look like the following year, so they can plan accordingly.
2. Show customers a holistic view of their accounts
Unified Managed Accounts can be a particularly beneficial account structure, allowing advisors to get a holistic view of their clients’ investments from a tax perspective. By consolidating all of their investment strategies into one account, advisors can see a 360-degree picture of a client’s entire investment portfolio in one place and coordinate the realization of profits and losses across the different strategies.
They can also provide urgent and comprehensive tax insights that can be presented in discussions and meetings. For example, an advisor may review all of a client’s investment strategies and come up to them and say, “That’s all the capital gains you’ve realized in the last year according to the budget you gave us — that’s more or less than you would.” how it is?” Then the advisor can show the client what needs to be done on their accounts to reduce or increase their overall capital gains realization.
The advisor may also ask, “Do you have any other realized gains that we should discuss as we consider what your tax bill will be next year?” This is a great way to start discussions about the client’s financial assets are not monitored by the advisor – and how the advisor can add value in these areas and perhaps bring in these assets and increase the share of the wallet.
3. Eliminate short-term capital gains
Long-term capital gains – capital gains on assets held for more than one year – are taxed as dividend income at a preferential rate (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, if an investor realizes a short-term capital gain, they will be taxed almost twice as much as if they realize a long-term capital gain. In addition, when you add state income taxes, the total marginal income tax rate in some US states can exceed 50%. For this reason, one of the most important advantages that an adviser can offer from a tax perspective is the reduction or elimination of short-term capital gains.
By using a holistic view and perspective of a client’s investments, an advisor can gain a comprehensive understanding of what a client’s long-term capital gains realization should look like, consistent with a client’s financial needs, goals and risk tolerance – and how short-term long-term capital gains should be can be reduced through a customer’s accounts.
They say that in a crisis you learn who your true friends are. Similarly, investors can learn the true value of their advisors during turbulent market conditions. The current economic climate offers advisors an opportunity to help clients consider how to adjust their investments to reduce risk and protect their portfolios.
Advisors can demonstrate their value by showing investors that they don’t have to let their aversion to 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 benefits for their accounts can only strengthen the advisor-client relationship in the long run.
Erik Preus, CFA, is Managing Director of Envestnet PMC, Envestnet’s portfolio advisory group.