In today’s fiercely competitive investment management landscape, financial advisors are encountering challenges from various fronts, including fellow advisors, brokers/dealers, insurance agents, robo-advisors, and self-directed investors. In this environment, where promising excess returns over market performance is unrealistic in the long term, advisors are exploring alternative avenues to enhance their clients’ investment outcomes.
While offering other services like financial planning and consultations is undoubtedly valuable, they often don’t directly contribute to improving the investment bottom line over a year. So, how can advisors truly augment investment performance without escalating risk? The answer lies in tax optimization, commonly known as “tax alpha.”
Tax alpha involves integrating tax-saving strategies into investment management, providing clients with both permanent and temporary tax savings. These strategies can significantly benefit clients and set advisors apart in the competitive landscape.
Permanent Tax Savings Strategies
Permanent tax savings are those that don’t necessitate repayment to the tax authorities. One such strategy is avoiding short-term capital gains, where assets held for less than a year incur higher tax rates. Investors can substantially reduce tax liabilities by deferring sales to qualify for long-term treatment.
Location optimization is another powerful strategy, offering both permanent and temporary tax benefits. It involves placing investments in the most tax-efficient accounts and aligning investment types with account types to minimize current and future taxes. For instance, holding tax-inefficient investments in tax-deferred accounts and appreciating assets in taxable accounts can lead to significant tax savings.
Temporary Tax-Savings Strategies
Temporary tax savings strategies, although postponing tax obligations, can still be valuable. Tax-loss harvesting, for instance, involves selling investments at a loss to offset gains, thereby reducing current tax liabilities. Additionally, choosing high-cost lots when selling assets and avoiding year-end capital gains distributions are effective strategies for temporarily lowering taxes.
Implementation of Strategies
Advisors can implement tax-saving strategies manually, automatically, or by delegating to specialized software or asset management programs. Automated solutions can ensure comprehensive implementation of tax strategies, minimizing the risk of overlooking tax-saving opportunities.
Communicating with Clients
Advisors must educate clients about the benefits of tax-saving strategies and quantify the tax savings provided. By explaining concepts like location optimization through various channels and providing personalized reports showcasing tax savings, advisors can reinforce the value they bring to their client’s financial well-being.
Conscious Buying of Individual Bonds
In the pursuit of tax optimization, the selection of bonds plays a crucial role. Certain types of bonds offer distinct tax advantages, making them suitable for inclusion in investment portfolios. Here are some considerations for buying the right kinds of bonds for tax reasons:
1. Tax-Exempt Municipal Bonds: Municipal bonds issued by state and local governments typically offer interest income exempt from federal taxes and sometimes from state taxes as well, especially if the investor resides in the issuing state. These bonds are particularly beneficial for investors in higher tax brackets, as they provide a tax-efficient source of income.
2. Treasury Inflation-Protected Securities (TIPS): TIPS are U.S. Treasury securities designed to protect against inflation by adjusting their principal value based on changes in the Consumer Price Index (CPI). While the interest income from TIPS is subject to federal taxes, the inflation adjustment on the principal is taxable only when the securities are sold or mature. For investors seeking protection against inflation with minimal tax implications, TIPS can be a suitable option.
3. Zero Coupon Bonds: These bonds pay no coupon to investors annually, so there is nothing to tax year in and year out. The entire yield of this bond type is paid out in the form of capital gains – which is far lower than the income tax rate for many investors. While the lack of an income is unappealing for many, the tax strategy is sound for those who are looking for yield with lower taxation.
4. Taxable Bonds in Tax-Advantaged Accounts: Taxable bonds, such as corporate bonds or Treasury bonds, are generally more tax-efficient when held within tax-advantaged accounts like IRAs or 401(k)s. Since the interest income from taxable bonds is taxed at ordinary income rates, sheltering them within tax-deferred accounts can help mitigate tax liabilities, allowing for greater compounding of returns over time.
In an era where investment services are increasingly commoditized, differentiation is vital for advisors to retain and attract clients. While financial planning remains essential, creating tax alpha can significantly enhance the value proposition for clients. By incorporating tax-saving strategies into investment management, advisors can deliver tangible benefits that positively impact clients’ investment outcomes.
