8 Ways to Create Tax Alpha
Here are some traditional and under-the-radar ways to help clients earn more after taxes.
Here are ways to help clients earn more after taxes.
IF THERE’S ONE THING EVERY CLIENT WANTS TO DO, it’s to make more money after taxes. Advisors can add value for clients when it comes to optimizing their tax tactics.
Here are eight strategies for generating tax alpha for your clients, from conventional practices to more-unusual offlabel product moves. Tax law is complicated, and these strategies can be as well, but making the effort can help advisors differentiate their practices.
TRADITIONAL TAX ALPHA
1. Product selection: With stocks repeatedly setting records this year, active mutual funds are passing through gains to clients. The average turnover of active equity mutual funds is 63%, according to Morningstar Direct. This creates both short- and long-term taxable gains, and also results in lower returns even before taking into account these taxable consequences.
Even formerly hot active mutual funds can get into a death spiral, creating a tax trap. For example, the Columbia Acorn Z (ACTWX) lost 0.44% in 2015, but passed on a $7.14-per-share capital gain when the fund had to sell stock to honor redemptions as investors fled.
Broad stock index funds of the mutual fund or ETF variety have little to no turnover, and leave you and your client in better control of when to recognize gains.
2. Asset location: Risk is determined by asset allocation and product selection. Once this is done, choosing the right tax wrapper is crucial.
Some assets are best located in taxable accounts and others in traditional tax-deferred accounts. In general, taxefficient vehicles with high growth potential, such as stock index funds, belong in the taxable accounts. That’s because the dividends are taxed at lower rates and the client is in control of when the gain is recognized.
Owning stocks in a traditional IRA or 401(k) account eventually turns what would have been a tax preference item into ordinary income, thus typically resulting in a higher tax rate.
Tax-free Roth accounts are a third tax wrapper. REITS or REIT index funds are perfect for this tax wrapper, because the dividends are taxed at higher rates and REITS also offer the opportunity for growth.
3. Tax diversification: I’m often asked which accounts I prefer — taxable, tax-deferred or tax-free wrappers. My answer is all three. None of us know what our tax rate will be in retirement, or what changes in tax law might occur.
Thus, using all three is a form of political diversification. If, for example, marginal tax rates increase, then the Roth would look attractive. If we move to a consumption tax like the Fair Tax Act, the client pays taxes on the money when she contributes and again when she spends the money.
4. Tax-loss harvesting: I tell clients who are fretting about portfolio losses, “I’m sorry for your loss, but make the most of it.”
While typically only a $3,000 loss per year can be recognized, an unlimited amount can be carried forward and used to offset future gains. Be sure to avoid buying back the same security within 30 days (wash rules). This can be done
without exiting stocks for a month by buying a similar fund.
5. Withdrawal strategies: Generally, clients should spend taxable assets first, taxdeferred assets second and Roth assets last.
However, clients often have an opportunity to pay taxes sooner at a lower marginal rate. If, for example, a client retires before age 70 but elects to delay Social Security until age 70, the client’s income may be very low, leading to a lower marginal tax rate.
This creates an opportunity to take funds out of the traditional IRA/401(K) wrapper sooner, with a lower tax rate, rather than later, when the client is taking Social Security and must take the RMD, leading to a higher tax rate.
Two ways of taking money out are making a simple withdrawal into a taxable
6. Multiple Roth conversions with a put to recharacterize: One way to get more money into the Roth tax wrapper is to convert traditional tax-deferred money to Roths. Every year, I do several Roth conversions and put each one in a separate asset class.
If I do the conversions in early January, I have over 22 months during which I can undo the conversion, in what’s called a recharacterization. I explain to clients that a traditional IRA/401(K) is really jointly owned by themselves and the federal and state governments. If the client is in the 30% marginal tax bracket, they own 70%, and a conversion is buying out the government’s share.
For example, if they convert three IRAS and one is in a REIT index fund that loses 37% of its value (as it did in 2008), recharacterizing essentially makes the government buy back its share at the original price.
Many states also have a pension exemption so some of the conversions can be free of state income taxes.
7. Using HSAS to get both a deduction and tax-free growth: If your client has a high-deductible health plan that qualifies for an HSA, they get a tax deduction in the year they contribute. They get the same benefit as a traditional IRA. But rather than reimburse themselves for out-of-pocket health care expenses, clients can pay with taxable dollars and keep a tab on expenditures.
This means they can reimburse themselves at any time, even decades later. They can also use these funds to pay Medicare premiums and long-term care premiums and expenses.
8. Use muni bond funds to get tax losses without economic losses: Interest rates have declined and muni-bond coupon payments are higher than the SEC yield. The SEC yield represents the fund’s true income and carves out any return of capital that is included in the distribution yield.
Vanguard Long-term Tax-exempt Admiral (VWLUX) has an SEC yield of 2.37% as of Oct. 26. Though this is the true income, the total distribution yield is 3.49%, meaning roughly 1.12 percentage points is return of principal from an economic perspective.
If this continued for a year, an estimated loss of the net asset value of 1.12 percentage points could occur. You can then have your client recognize this loss, even though they actually received the 1.12 percentage points via a tax-free coupon payment.
If these strategies are implemented correctly, clients will make more money after taxes, often while actually lowering risk.
I tell clients who are fretting about portfolio losses, “I’m sorry for your loss, but make the most of it.”
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colorado. He also writes for The Wall Street Journal and AARP the Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_investing.