New investors are usually given very simple advice to get started: Buy a broad market exchange-traded fund or two and hold them for the long term. As you accumulate wealth and become more educated about the process, your strategies tend to become more sophisticated, ranging from actively managed mutual funds to direct indexing to fine wine collections. Your potential return increases greatly, but so do your taxes.
Financial advisors have software that can run hundreds of scenarios about the potential market return on your investment portfolio, but until recently, measuring the tax impact of investment holdings was a tedious manual exercise performed on spreadsheets.
“It took hours for one particular client,” says Andy Watts, a board-certified financial planner and vice president of planning and growth solutions at Texas-based Avantax Wealth Management, which specializes in portfolio tax planning. “It wasn’t scalable.”
But now financial advisors from independent money managers to representatives of large brokerage houses have access to software that can help speed up the process. The algorithms identify which items in a portfolio are causing a tax burden and offer suggestions on how to reduce that impact over time.
What is tax drag?
Investors pay taxes on their holdings in a variety of ways. When you sell a stock, you can either make a short- or long-term capital gain, or you could have a loss that you can use to offset your income. But even just holding an investment can generate taxes, either from dividends and interest or from capital gains returned by the funds themselves, which is most common with mutual funds.
“A lot of people are very surprised when they open these consolidated financial statements from their brokerage firm, especially if they haven’t made many changes,” said Aaron Klein, CEO of Riskalyze, an Auburn, California-based company. based company that provides technology solutions for advisors to measure risk tolerance and overall portfolio performance.
“Tax drag” is the amount a portfolio is charged by paying more to the IRS than you have to because there are more efficient ways. Much of this depends on asset location rather than asset allocation, meaning the accounts in which you hold certain types of investments are more important to taxes than the specific funds you might choose.
“If a high-net-worth client lives in a high-tax state, it may be better to have their fixed income municipal bond income in a taxable account and have all of their active stock trading in their qualifying, tax-deferred accounts,” said Mark Hoffman, CEO of based-based LifeYield in Boston, which offers a suite of tax optimization software used by more than 100,000 financial advisors. LifeYield also evaluates stock options and other deferred compensation strategies for high earners and savings strategies for retirees.
The funds you select also have an impact.
“Capital gains are largely a function of an investment manager’s decisions,” says Klein. “You can put two mutual funds side by side with the same goal, and one might have a very disciplined tax advisor and the other might not be particularly focused on that.”
What can you save?
If you have hired a financial advisor in the past, you might have assumed that your portfolio was already optimized for tax efficiency, but advances in technology show that this is not really the case.
On the LifeYield scale, zero is the worst score out of 100, and most often they see portfolios at 50 when aiming for at least a 70-80 score. The typical investor owns between four and eight different investment products spread across five or more accounts. Some studies show that reducing a portfolio’s tax burden can save anywhere from 0.5% to 1.5% of account value.
Russell Investments calculated an example where a $500,000 portfolio would generate a potential tax bill of $12,000 when factoring in a mutual fund’s average capital gains distribution. Invested in a way that does not incur a tax burden, not only would the client save this immediate taxpayer money, but over 10 years the compounded growth would mean the account would have grown an additional $188,000, with an assumed annual return of 7, 5%
“Tax drag is compounding kryptonite,” says Klein of Riskalyze.
There are, of course, easier ways to solve tax burdens than complicated software that you can now only access through wealth managers, and that’s designed to streamline it from the start.
There’s no technical reason why a low-cost ETF strategy that works for new investors can’t work for the rich, says Mitch Tuchman, managing director of Rebalance 360, an independent investment firm. “I do it. I live it. And I do my own taxes,” he says.
“It would be wonderful if the world were that simple,” says Hoffman. “But we generally get accounts and portfolios that have never been coordinated, and the only way we can offer clients that level of service is through technology.”
This column was first published on Barron’s.
