Reducing the impact of taxes is one of the best ways to help clients keep more of their wealth. Indeed, high-net-worth clients continue to rank tax management solutions as their top financial need. Advisors can help clients stay one step ahead of the drag from taxes by taking advantage of the unique tax-management opportunities that exist during each of the three key phases of an advisor-client lifecycle:

The cycle begins: As a client transitions assets to an advisor, opportunities often arise to manage large unrealized capital gains and concentrated stock positions.

The investment phase: During the main wealth-building phase of a client’s investment lifecycle, tax-loss harvesting can contribute meaningfully to growing and compounding returns over time.

The access phase: When a client’s investment accounts are eventually used to provide retirement income or as a source of gifting and inheritance, a different set of tax-efficient strategies can be used to preserve wealth.

A separately managed account (SMA) using intelligent tax technology offers critical advantages to help advisors and investment managers tailor solutions to each client’s individual tax situation, investment objectives and risk tolerance.

The investing phase: Growing and compounding wealth

Once a client’s account has fully transitioned or is at its target state, the client-advisor lifecycle shifts into the prime wealth-building phase, which can last for a number of years. In this part of the cycle, the focus is on maintaining the appropriate level of risk to generate the desired level of returns, while seeking to preserve and compound gains by reducing tax drag.

The tax-managed SMA operates under a dual mandate: seek to deliver the targeted investment experience (whether index or active), while harvesting losses opportunistically. By investing in individual securities, and looking to loss harvest throughout the year, a tax-managed SMA can find opportunities at the individual stock level in both up and down markets.

For example, the S&P 500 had positive returns in 22 of the past 30 years, so an investor looking to harvest losses at the index level in December may have only had an opportunity in three of these years. If the account was able to harvest losses at the individual stock level every December, the opportunity improved — on average, 146 stocks traded at a loss of 5% or more at the close of each year.

However, a year-end loss-harvesting strategy can be boom or bust, depending on how the market performed; 2018 and 2022 offered many opportunities, but there was not much to do in 2019, 2021 or 2023. An account that can harvest losses at the individual stock level throughout the year may see many more at bats: 372 stocks, on average, traded at a loss of 5% or more at some point through the year, generating a healthy opportunity set even in 2019, 2021 and 2023, with 177, 488 and 360 names, respectively, due to intra-year opportunities.

Comparing tax-managed SMA managers is difficult. There’s nuance in how frequently managers harvest losses over the course of a year or think about their dual mandate of seeking to achieve the investment return of an underlying investment strategy (whether passive or active) while generating taxable benefits for a client by harvesting tax losses.

In “Continuous Tax-Loss Harvesting Yields More Potential For Tax Savings,” we explored how a daily and continuous approach to monitoring for loss-harvest opportunities may offer greater tax savings than a monthly approach. Our analysis found an average annualized uplift of approximately 30 basis points (bps).¹

We have spent less time highlighting the risk-management element of a continuous approach, which includes limits on active sector and stock risk relative to a target exposure, but it’s actually quite important. If an account drifts too far from its target, the client may be locked into risks they don’t want — unless they realize gains to rightsize their portfolio positioning.

The risk-management benefit is also important because over time, a Tax-Smart SMA account will hopefully appreciate and find fewer opportunities to tax-loss harvest. On average, loss-harvesting potential tends to erode over time, due to two forces:

• Markets historically go up. Hold on to any stock long enough, and historical market data shows its value is likely to increase over time. Therefore, a client’s potential for tax harvesting is typically highest when first funded, and embedded losses tend to diminish over the long haul.
• Harvesting losses will eventually decrease a portfolio’s cost basis over time. If the stocks purchased as substitutes for the ones harvested appreciate, the spread between their cost basis (the price at which they’re bought) and the stock’s current price increases — and exacerbates the first point.

Indeed, the benefits of loss harvesting are reduced over time, with roughly 70% of the losses coming in an account’s first five years if no cash is added. Fortunately, a client can combat this scenario by adding dollars to their account to create new cost bases. Introducing fresh tax lots into a portfolio may create additional opportunities to harvest those lots amid any ensuing volatility. We analyzed the cumulative losses harvested over 15 years, on average, for portfolios that initially invested $1 million in a tax-efficient strategy. Portfolio A (blue line) received no subsequent cash contributions. Portfolio B (dotted green line) added cash contributions of 5% of its market value at the beginning of each year.

Portfolio A’s tax-loss harvesting potential increasingly flatlined relative to Portfolio B, where annual cash contributions injected a fresh set of tax lots each year into the account, increasing the opportunity for tax-loss harvesting during any subsequent market volatility.

Managing and optimizing portfolios with Tax-Smart strategies

Over the course of your relationship with your clients, you can help them maximize the power of compounding by minimizing tax drag. After transitioning assets smartly and building wealth efficiently over time, help your clients optimize how they access their wealth by spending from tax lots with the highest basis and gifting from those with the lowest. Tax-managed SMAs provide you and your clients with the most flexibility to stay one step ahead of taxes at each stage of the client-advisor lifecycle.