Tax-managed investing 101: Understand the basics and slay the beast

Why do investors go to financial advisors and planners? To get assistance with a variety of investment and planning challenges, obviously. One of those challenges is taxes. Investment portfolios can and do generate taxable events for clients. The cost of taxes can be significant for investors. So it’s important that the management of these assets take the cost of taxes into consideration. Often this isn’t done. Why? It comes down to three hurdles that can be easily overcome.

It’s confusing. Income taxes alone can be difficult, but then adding taxes on investments can complicate things even further.
It’s math. This time, the math matters, because it’s all dollars and cents. And the less you lose in taxes, the more money you get to keep. In equation terms, you might say, $$ > $$ - ¢¢.
It’s big. Reducing taxes is clearly a big opportunity, and sometimes the size of an opportunity can be intimidating. Advisors may wonder what types of assets, clients, and accounts are best suited for a tax-aware approach.

Huh? What did you say? I don’t understand.

Tax-managed investing doesn’t have to be so confusing, but the financial world is wonderful at overcomplicating simple things—all the way down to the language used to describe taxable and non-taxable accounts. For example, in industry speak, we call taxable accounts non-qualified and tax-advantaged accounts qualified. Let’s make these terms simpler to understand:

Qualified – This category includes tax-advantaged accounts—either tax-exempt or tax-deferred—such as IRA’s, 401Ks, 403Bs, 529s, and HSAs. In these types of accounts, investors may receive distributions in the form of dividends and capital gains or may buy and sell positions without any tax implications. Whether we use the phrase tax-exempt, tax-deferred, tax-advantaged or qualified, when it comes down to knowing what tax rate applies each year, the answer is simple: 0.00%.

Non-qualified – These are taxable accounts where investment income is taxed annually. Direct-bought mutual funds, bank accounts and brokerage accounts are some examples. For these accounts, the answer is not as straightforward. What tax rate do we use? Is the gain long-term or short-term? Are there realized losses available to offset the gains and how can they be used? And don’t forget the wash sale rule. What about interest? What tax rate do we use for interest? And dividends—wait, there are qualified and non-qualified dividends, but those are different definitions than qualified and non-qualified accounts? What is a 1099 Form? What about K1 forms? And what are the actual tax rates? And then there are state and local taxes in addition to the federal taxes. It’s all confusing.

Why do taxes matter? Because 22 cents of every dollar matters

Much of the time, investors and advisors think the size of the account is the most important factor. But when it comes to taxes, the size of the account in question isn’t as important as the level of income the account generates. It’s income that triggers the different tax rates that cause big tax bills.

According to 2019 U.S. tax law, when a married couple filing jointly crosses over $78,950 in income, or a single filer crosses $39,475, they are in the 22% marginal tax bracket at the federal level—that’s 22 cents on every dollar of income. At this level, taxes clearly matter to investors. And at this level, the tax on long-term gains and qualified dividends also jumps from 0% to 15%. Ouch.

Investors earning or expecting to earn income above that level should be actively thinking about the tax implications of their portfolios. We believe they should be using a tax-managed solution within their taxable accounts.

Who cares? The types of clients and assets where tax management really matters

Rather than targeting everything, it’s better to focus efforts where help can be applied specifically—to specific clients. This is a list of the seven top sources of taxable assets we see through our work. Using this list, we believe advisors can focus their efforts on the clients and situations that need tax management the most.

The top seven sources of taxable assets

The sale of real estate
The sale of a business
Deferred compensation
Inheritance
Insurance proceeds
Trusts
Current taxable assets

1. The sale of real estate or other assets due to downsizing

The last child is now out of the house.

Advisors are frequently meeting with investors who are now or soon will be single-nesters. For an investor with departing children, it can finally feel like it is my turn to enjoy an easier and simplified lifestyle. This may mean getting rid of a car, cleaning out the basement and, in many cases, selling the house completely. In certain parts of the country, the sale of the home is also being accelerated due to the inability of the investor to deduct SALT (state and local taxes) above the $10,000 limit. The sale of the house results in a sizable capital gain from the price paid many years ago. To reduce taxable gains, proceeds are often taken to purchase a new, smaller house. The end result is a large remaining pool of taxable capital that needs to be invested. In one situation we saw recently, investors sold their home for $1.2 million, purchased a new home out-of-state for $400,000 and had the remaining balance that they needed to reinvest. This was a situation where a tax smart solution made great sense.

2. Sale of a business

Retirement is what many of us look forward to—golf, gardening, travel, time with the grandkids and no more morning wake-up calls. For business owners, it can also mean selling all or part of their businesses. Regardless of the type of business, or whether they are selling to their employees or to another company, the sale of a business is still an asset sale. That means it gets taxed as a capital gain in most cases. We’ve worked a lot of these situations the last few years and have found that the sale of a business is a personal and emotional event. When an investor sees the capital gains tax bill, the emotions can get even more severe. That’s why advisors need to take better control of that tax bill going forward and need to think about how tax-management on the invested proceeds can help with long-term planning.

3. Proceeds from stock grants and deferred compensation plans

Here’s a common situation: A senior executive earning a high income retires. After working a lifetime at her job, she exercises her stock options of $3 million and triggers a significant taxable gain. At the same time, she also is handed her deferred compensation of $1.5 million. which she’s been saving for many years. Because she was focused on the account value, the actual cost of taxes due was not top of mind. The outcome of this scenario is a sizable tax bill. Investors who save on a tax-deferred basis and then are suddenly confronted with a large tax bill are often shocked by the outcome. We’ve seen that the last thing they want to do is to place their remaining assets into a solution with no tax efficiency. Instead, we believe the investor should place these assets into a tax-smart solution that actively works to reduce capital gains and minimize excessive tax exposure. The investor gets to enjoy a solution that is both tax smart and liquid.

4. Inheritance

While a death is a sad time for families, an inheritance provides an opportunity to plan for the future. In this example, let’s assume a husband and wife in their sixties receive a $3 million inheritance.

Through the benefit of a step up of cost basis, most of the inheritance came over to them tax-free.
Both are retired and currently receive small pensions. They seek additional income, but want to do so in a manner that does not trigger unwanted taxable capital gain distributions.
After paying off their mortgage and other debts, they have $2 million remaining.
Their goal is to generate a 5.5% after-tax return on these remaining assets to further supplement their income.

With the help of their advisor, they decide on a tax-smart portfolio, diversified across stocks, bonds and real assets. The portfolio is designed to provide instant liquidity, the potential for growth and the ability to withdraw assets on a systematic basis. Loss harvesting within the portfolio provides the opportunity to minimize capital gains, while interest from municipal bonds offers income exempt from taxes at the federal level. This situation illustrates a way in which an investor may create income, generate potential gains and minimize tax drag, all with one portfolio.

5. Insurance payouts

Similar to an inheritance, it is typically a sad event that generate an insurance or death-benefit payout. However, in many cases this payment comes tax-free and the recipient can now plan out how to have it become a pool of after-tax wealth. Through the use of a tax-smart approach and active tax-management, a disciplined investment plan for this payout can result in a beneficial retirement nest egg.

6. Trust accounts

Trust accounts are created for a variety of reasons. In many cases they are created to support the ongoing needs of a specific individual or organization. Trusts that aren’t passthrough entities—meaning trusts that have their own tax identification number and file their own tax return—have a unique tax situation. Once taxable income exceeds $12,750, these trusts are most often taxed at the highest tax level possible. Today that rate is 37%, in addition to the 3.8% Net Investment Income Tax (NIIT).

It doesn’t take much for a trust account to quickly find itself in this highest tax-bracket. For example, a $1 million trust account yielding 2% could be paying a maximum level of federal taxes, in addition to state and local taxes. Investors are finding that the use of a tax-smart approach to the management of these underlying assets can make a significant difference to long-term returns.

A client we worked with recently had created a $6 million trust account to care for the financial well-being of her two grandchildren. The account was initially invested in a diversified portfolio of equities and fixed-income products. While the account did grow in value, it had to pay significant taxes due to the dividends, interest and realized capital gains that were paid each year. After several years of being burdened with this tax situation, a decision was made to move into a solution that would maximize the after-tax return. Tax-loss harvesting was instituted, a focus was made on long-term gains over short-term gains and municipal bonds were introduced into the portfolio. The result was a tax-smart portfolio that had the potential for growth to benefit the grandchildren. This approach made a significant difference to the investor.

7. Current taxable assets with an unwanted tax bill

Many investment products are managed in such a way that the objective is to maximize the pre-tax return, while the after-tax return is secondary, if considered at all. Too often we hear investors say, “I just want the highest return possible.” This is often said without understanding the cost of taxes and the impact taxes have on that return. Little to no consideration is given to seeking ways to reduce capital gain exposure or to seeking more favorable long-term—versus short-term—gains scenarios.

In many instances, these return-seeking products are fine to use within tax-advantaged accounts, where taxes are exempt or deferred, but these same products can cause great tax costs within taxable accounts. A specific example we saw recently was an investor holding a sizeable $6 million stake in a large U.S. mutual fund. The fund invested primarily in U.S. domestic equities and some fixed-income products. The investor opened the account in late 2017. By December 2018, the account was essentially flat. If the investor had kept the account, she would have incurred a capital gains distribution of approximately 9.6%, or $576,000.

A decision was made to close this account before that distribution and thus avoid having to receive a massive unwanted tax bill. Proceeds from the account were moved to a tax-managed portfolio where capital gains, dividends and interest could be managed in a more tax-efficient manner. This is just one example of just how important it is for advisors to consider after-tax returns when deciding what products are most suitable for a specific account. Placing a tax-inefficient product within a taxable account can have potentially horrific results.

The bottom line

Taxes matter. Investment portfolios can and do generate taxable events for clients. And the cost of those taxes can be significant for investors. Without help, tax-managed investing can be a beast to implement. But by partnering with a skilled, experienced partner, you, the advisor, can be a tax hero. You can slay the tax beast and help your clients minimize the impact of taxes.