When investment accounts are used for retirement income or as a source of gifting and inheritance, a different set of tax-efficient strategies can be used to preserve wealth.
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 access phase: Spending and giving accumulated wealth
As the advisor-client relationship moves into the access phase of the lifecycle, the transition may be gradual or triggered by a major life event, like retirement. Clients begin to think about their need for income and desire to leave a legacy, whether through philanthropy or providing for loved ones.
A common misperception around tax-managed SMAs is that the benefits disappear completely after a period of time as tax-loss harvesting opportunities decline. Yet a tax-managed SMA offers inherent benefits when clients want to start accessing their wealth. At the end of the day, there are only three things a person can do with their accumulated wealth: spend it, give it away or leave it to another. These options have different tax outcomes. Spending accumulated wealth requires liquidating investments and realizing capital gains, which generates a tax bill. Gifting offsets adjustable gross income, creating tax benefits for clients. Leaving investments as part of an estate resets the cost basis.
Let’s discuss the outcome over the 10-year period, the market returned over 200% during that time period. A client who invested in an ETF would essentially have a single investment with a gain of more than 200%, leaving no potential for different cost bases that can be used to optimize spending or gifting.
If, on the other hand, the client had invested in a tax-efficient SMA, an advisor can see what the distribution of lots looks like at the end of the 10-year period and use positions in a tax-efficient way. Gifting stocks with a lower cost basis removes the overhang of capital gains in the portfolio faster. Spending lots with higher cost bases creates a lower effective tax rate when accessing wealth, preserving more for inheritance. For example, a roughly 14% effective tax rate when withdrawing from ETFs could potentially be reduced to less than a 2% effective tax rate on one-time withdrawals of up to 10% of an account’s value; a roughly 6% effective tax rate could be achieved through a five-year program of 4% withdrawals per year.
In a worst-case scenario, in which a client entirely liquidated their Tax-Smart SMA all in one go, the additional wealth compounding over the lifespan of a Tax-Smart SMA may more than make up for the liquidation taxes either on a stand-alone basis or compared to the experience of investing in and then liquidating an ETF. In our analysis of the 10-year period 2013 through 2022, an initial $1 million invested in a Tax-Smart SMA had an annualized return post-liquidation 45 bps higher than an ETF, or 22bps higher, assuming a 35bps fee. Over a 15-year period the outperformance was even greater: 164bps and 149bps, respectively.1
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.