In brief
- Technology has profoundly enhanced how tax-smart portfolios are managed.
- Today, tax-tech can also improve the tax consequences of transitioning portfolios and eventual spending.
- Advisors using a personalized, tax-smart approach can help investors keep more of what their portfolios earn, across market cycles and life stages.
Over a lifetime, an investor's decisions are impacted by a myriad of factors. From a college graduate's first 401k contribution to the establishment of a trust designed to benefit the heirs of their heirs, tax decisions are ever-present.
For taxable portfolios, it's essential to understand the causes and impact of capital gains taxes - an essential first step in helping investors keep more of what their portfolios earn. We introduced key concepts and two capital gains scenarios in an earlier blog and wrote in a little detail about the first, navigating the tax challenges of active management. Here we delve into a little more detail on the second scenario - how investors and advisors can, together, mitigate the tax impact of the investment decisions they have control over.
Tax-smart investing today
Experienced investors understand fully that the road to investment success is never straight. Periods of accumulation and decumulation are rarely clearcut, and that market projections and market returns rarely jibe. Markets move, goals change, and life happens. But with volatile markets and fluctuating portfolio values come expanded opportunities to mitigate the impact of capital gains and, thus, enhance after-tax outcomes.
Historically, harvesting losses required the manual monitoring of markets and securities. An approach only viable for the largest taxable portfolios and beneficial only for large, often infrequent trades. And even then, limited in scope and effectiveness by manual processes, incomplete analytics and lack of scalability. No more. Technology hasn't just changed the game. It's changed the game, the rules, and often the results.
Tax-smart asset management has evolved...rapidly
Technology can now identify a larger set of harvesting opportunities than could ever be done manually. By continually monitoring the price fluctuations of markets and portfolio positions - technology-enabled tax-loss harvesting (what we call tax-tech) has simultaneously expanded the scope and improved the effectiveness of tax-smart investing. Come of age, it is delivering quantifiable benefits with increased accessibility to more investors. But a key and once well-founded concern emerged - how could portfolios stay aligned with portfolio and investor mandates as transactions increased?
A portfolio designed to generate returns similar to those of the S&P 500 should of course be aligned and stay aligned with that remit. Today the same tax-tech that monitors portfolios for harvesting opportunities also monitors portfolios for alignment and tracking error. Multiple tax lots, the impact of trades and wash sale restrictions are now evaluated and optimized with ease, accuracy and scalability. Tracking guardrails can be defined, continually monitored and easily adhered to.
Beyond portfolio management: More control over the cost of portfolio transitions
By intelligently pairing portfolio gains against losses, both initially and over time, the tax cost of transitioning to a new portfolio can be reduced in the same manner. A tax budget for the initial transition can be met, while the balance between full implementation of a new portfolio and the taxes associated with that implementation can be measured, balanced and then optimized.
Let’s say an investor wants to move their $10 million portfolio to one that better fits their current objectives and risk profile. The incoming portfolio has $2 million in unrealized gains. They could transfer all of the original portfolio to the new target portfolio in one step, realizing all $2 million of their gains and incurring a sizeable tax bill.
A tax-smart transition, however, provides a second path and an increased level of control beyond "all or nothing" Our investor can opt to transfer a portion of the original portfolio, limiting the up-front tax impact to a predetermined budget. By analyzing the tax profiles and risk exposures of the incoming investments and comparing them to the new target portfolio, a tax smart transition allows the investor to get the most “bang” for their capital gains “buck.” Positions that least align with the target portfolio are prioritized for sale, while positions with exposures more similar to the target portfolio are retained. Portfolio composition and taxes are intelligently balanced and optimized. This ensures that the initial transition is as complete as possible given the desired tax budget. It then allows for subsequent transitions over time to take advantage of annual exclusions and subsequent market events.
Between the extremes: Tax-smart spending optimizes utility
Whether as part of a planned decumulation or driven by a large transaction, a tax-smart approach to spending can improve after-tax outcomes and help investors keep more of what their portfolios earn. A retiree may benefit from lower tax rates should their income decline. But for many, the impact of capital gains could still be considerable after a lifetime of saving, investing, and compounding.
A simple strategy of funding expenses and entertainment by selling those securities with losses or the fewest gains can certainly be effective in the short run. It defers the realizing of gains and so the subsequent tax bill. But over time selling the "low performers" could leave a portfolio out of synch with investment objectives, and that could be more expensive. At the other end of the spectrum is selling while maintaining the portfolio's composition intact. For example, an investor liquidates 4% of their holdings each year with no regard for tax optimization. Portfolio composition is maintained, but the tax impact is ignored.
Tax-smart spending strategies can add value in these situations. When securities need to be sold, the tax cost of that sale can be reduced by, once again, intelligently pairing security gains with losses elsewhere in portfolios while simultaneously optimizing the portfolio's “post-withdrawal” composition and risk. With their advisor, an investor can see the full tax impact of their decumulation transactions and make intelligent tradeoffs around taxes and portfolio tracking risk. Once again information is power.
Getting to better after-tax outcomes
For investors with taxable accounts, a full understanding of the tools, strategies, and technology available to control the impact of controllable decisions is invaluable. Today, technology enables investors and their advisors to reduce the gap between what portfolios make and what investors keep. As baby boomers continue to retire the wealth management industry continues to consolidate, it's more important than ever for advisors to be able to differentiate their services and help their clients mitigate the tax impact of money in motion. That's why, across markets and market cycles, across strategies and investors' life stages, J.P. Morgan is committed to being the industry standard for personalized, tax-smart investing.