Asset Location: Nine Tips to Create ?Tax Alpha?

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

With campaign season finally over, taxes are going to dominate the debate in Washington in the months ahead – however things shake out at the polls today. It’s going to be confusing; it’s going to be uncertain. But many of the most critical questions advisors will ask can be answered with an analytical approach to deciding where to “house” assets – in taxable or tax-sheltered accounts.

Here are just a few such questions: What if dividends lose their “qualified” status, which allows them to be taxed at 15%? How should advisors prepare for likely increases in capital gains rates? What assets are best to hold in a Roth or a 529 plan? And what about a variable annuity – will purchasing one help?

When it comes to those questions and others, advisors can systematically analyze the tax implications of high-net worth portfolios and generate actionable advice as a result. In what may be a low-return environment for several years, minimizing taxes is a great way to endear ourselves to clients in an area far too complicated for them to do themselves. Be a hero and generate what I like to call “tax alpha”!

Crafting the process

Determining the optimal location (in the tax status sense) of an investment should be a distinct step in your investment process.  Too many advisors forget or overlook this important consideration, which is perhaps unsurprising, given how complex our ever-changing tax code has become.

In years past, many advisors used mostly straightforward stocks and bonds, but those days are long gone. Accompanying the incredible proliferation of investment vehicles has been diversification available across an ever-broadening set of global markets. And, facing a highly volatile and uncertain market, more and more advisors are making short-term tactical trades, which can be expensive tax-wise without proper planning. All of these modern realities are making tax considerations more and more complicated to unravel.

It can be hard to know where to begin.

One way to start is to make sure you’re asking the right questions when you reach the location phase of your process. Here are several that all advisors should be asking:

  • Which asset classes do clients currently hold, and what embedded capital gains are in each account?
  • What new asset classes would clients ideally embrace, once their financial planning and risk tolerance has been reassessed?
  • Which managers are best to capture the targeted asset classes? What should the mix of actively managed funds, separately managed accounts, or passive funds be?
  • How do income and estate tax considerations affect the choice between taxable and tax-deferred accounts?
  • What are the tax implications of portfolio rebalancing?

Thinking holistically

With those considerations in mind, advisors should begin by thinking holistically. Most clients want to maximize family wealth, so start by considering a client’s accounts, including both those that are currently taxed and those that are sheltered, all together at once. Taxable accounts generally include brokerage accounts, trusts and children’s custodial accounts. Sheltered accounts include annuities, the cash value of insurance policies, 529, 401(k), IRA and Roth IRA plans.

Next, put everything on a spreadsheet, organized by asset class – I call this the family investment matrix. (This is a useful exercise in its own right – I find many clients have an epiphany when they see their asset allocation in its totality for the first time.)

When it comes to the location issue, the key is to understand thoroughly the possible taxes each investment may incur. How is each client account taxed, both as income in the short term and, eventually, for estate-tax purposes? What is the character and timing of taxable gain recognition for each investment manager? Will 1099s and K1s include ordinary income, short- or long-term capital gains, qualified or non-qualified dividends, or foreign tax credits?