Value of an Advisor: T is for tax-smart planning and investing

Executive summary:

• When it comes to investing, it's not about how much a client earns from their portfolio but how much they get to keep.
• A tax-smart advisor can help their clients minimize the tax burden on their portfolio by considering both the obvious taxes on investments and the hidden ones generated by typical fund activities.
• Active tax management is one of the most important activities advisors can do to bring value to their clients.

Taxes may be the biggest fee your tax-sensitive clients are paying on their investment portfolios. And neither they nor you, their advisor, may be aware of just how big that fee is.

There are the obvious taxes – those that are paid on dividends, interest and capital gains.

But there are also hidden tax costs. These are a little bit like a tax "iceberg" hiding beneath the surface: taxes generated by rebalancing or changes in asset allocation, managers, or funds in a portfolio, among other activities. More on that soon.

How much do all these taxes add up to? According to Morningstar, active U.S. equity funds gave up on average 1.72% of returns to taxes every year in the five years ending December 2023.¹ That means a mutual fund with a 10% pre-tax, three-year annualized return actually would have had an annual return of only 8.28% on an after-tax basis. This tax "drag" is significantly larger than the total fee most advisors charge. That tax drag represents money that is no longer available to invest and compound. And that can add up to be real money for real people living real lives.

So, taxes matter.

In this blog, we are going to look at the value an advisor can provide when they consider taxes throughout the investment process. This doesn't just mean tax-loss harvesting to offset capital gains taxes. It also means minimizing the tax cost of dividends as well as interest payments; carefully timing and managing portfolio turnover and trading activity and maximizing the use of tax-lot level accounting, among other strategies. All of that is part of what we refer to as active tax management, and it is one of the most important activities advisors can do to bring value to their clients.

This is the fourth and last blog in our 2024 series on our Value of an Advisor study, discussing why Russell Investments believes in the value of advisors, based on this easy-to-remember formula:

We've previously written about the A in our formula, which stands for active rebalancing and asset allocation, the B, which stands for the behavioral coaching helps keep clients invested in difficult markets, and the C, which is a growing trend as investors demand more personalized services and solutions.

In this section, we're talking about T, which stands for tax-efficient planning and investing. Because it's not about what investors make. It's about what they keep.

How much could tax management save your investors?

Taxes can seriously erode returns. While downward fee pressure can mean downward value trends in other areas, we believe advisors who focus on tax-efficient investing can distinguish themselves and demonstrate differentiating value.

Just how much return can be added with a tax-managed approach to building an investor's portfolio? First you need to understand how much is being lost to taxes, and where it's all coming from. Many investors often focus on just one aspect of a problem, overlooking the fact that investment challenges, like taxes, have multiple dimensions that need to be addressed.

In its simplest form, the tax impact on investments come from taxable Distributions. Many investors know these as capital gain distributions, dividend distributions, and interest payments/distributions. But what is the source of these, are they necessary, were they created intentionally or are they symptomatic of other things occurring in the investment portfolio, and then importantly - how are they taxed? The illustration below shows many of the distributions that investors see and feel (i.e. top of the iceberg). It also shows and identifies other activities that, when not done with a taxable investor's best interests in mind, can in many cases substantially increase taxable distributions as well as an investor's tax bill.

Total tax cost: Adding it all up

The key issues to think about when it comes to the hidden tax costs (bottom of the iceberg):

• How often is the portfolio rebalanced?
• What is the process for changing out funds (mutual funds or ETFs) in an investor's portfolio?
• How are money manager changes made in a multi-manager portfolio or separately managed account?
• How often is a portfolio "re-allocated"?
• How frequently is trading being done?
• Are the portfolios being managed "tactically' or "strategically'?

It may seem like these issues wouldn't have much of an effect, but it can be large. Frequent re-allocations and re-balances may make it look like "something is happening" but this may just be "smoke-and-mirrors" activity where the effect could be no improvement in return but a much higher tax bill. When it comes to being tactical or trading frequently, this could more significantly impact a portfolio's tax cost. Money manager and fund changes should be done with intent, where a risk or return improvement is significant enough to offset the negative tax impact of the change. The impact of taxes is real on a client's after-tax wealth.

Taking these impacts into account when considering portfolio activity and quantifying the tax impact alongside the risk and return benefit is crucial to success. That's where the 1099-DIV tax form can come in handy. This tax document can be a treasure trove of facts and figures that help analyze a client's tax health and whether their tax costs are higher than they could be – and should be.

The most important thing is not how much an investor made on their investments, but rather how much they get to keep. Net of taxes is more important than gross of taxes. Even 1% in tax drag every year can add up to a substantial sum over time. Then when you consider the loss of the compounding impact on a portfolio, well, that could mean the difference between a comfortable nest egg in retirement and one that is not. Helping your client feel confident in their nest egg is a lot of the value you as an advisor can add.

Are you a tax-smart advisor?

A tax-smart approach can reap benefits, both for the success of your clients and how it can differentiate your practice. Many advisors already think they have taxes handled, so we encourage them to answer these five questions:

1. Do you KNOW each client's marginal tax rate?
2. Do you PROVIDE intentionally different investment solutions for taxable and non-taxable assets?
3. Do you EXPLAIN to clients the benefits of managing taxes?
4. Do you PARTNER with local CPAs to minimize tax drag?
5. Do you REVIEW your client's tax returns?

If you can answer yes to all five of these questions, then congratulations, you're already a tax-smart advisor. If you answered no, then we're here to help

While it's important to always keep taxes in mind when investing, there are two key dates in the year that advisors should focus on to assess a client's tax situation: 12/31 and 4/15. If all you look at is the total portfolio growth that happened at that year-end date, without thinking about the April 15 tax bill due date, then you may be missing a serious opportunity.

The opportunity for advisors to shine. Simply walking through the different tax rates on different investments and discussing the implications and income impact for clients can be truly beneficial. (Again, the 1099-DIV form can be your best guide.) On their own, clients are unlikely to connect the dots between distribution impacts and their total wealth return. You, the advisor, can reveal what they may be sacrificing to taxes. And better yet, you can do something about it. A tax-efficient approach may help you provide a significant reduction in tax drag between one year and the next.

Communicate your value

This is the final installment of our 2024 Value of an Advisor series. But all this proven value that we've discussed in this blog post, in the series, and in the full report, can go unnoticed by your clients without one vital action on your part: communication.

Advisors need to communicate the value they provide to their clients. After all, your value is only as good as the client experience that you are reliably delivering, clearly communicating, and constantly elevating.

So then, what are you going to do to elevate your value? A tax-efficient approach might be your best place to start.

¹ Data was derived by creating table of all U.S. equity mutual funds and ETF's as reported by Morningstar. Calculated arithmetic average for pre-tax, post-tax return for all shares classes as listed by Morningstar.

Morningstar Categories included: U.S. ETF Large Blend, U.S. ETF Large Growth, U.S. ETF Large Value, U.S. ETF Mid-Cap Blend, U.S. ETF Mid-Cap Growth, U.S. ETF Mid-Cap Value, U.S. ETF Small Blend, U.S. ETF Small Growth, U.S. ETF Small Value, U.S. OE Large Blend, U.S. OE Large Growth, U.S. OE Large Value, U.S. OE Mid-Cap Blend, U.S. OE Mid-Cap Growth, U.S. OE Mid-Cap Value, U.S. OE Small Blend, U.S. OE Small Growth, U.S. OE Small Value.

Methodology: average after-tax return for the large cap category reflects a simple arithmetic average of the returns for all funds that were assigned to the large cap category as of the end date run. For funds with multiple share classes, each share class is counted as a separate "fund" for the purpose of creating category averages. Morningstar category averages include every type of share class available in Morningstar's database. Large Cap/Small Cap/Municipal Bond determines based upon Morningstar Category.