8 Ways to Cre­ate Tax Al­pha

Here are some tra­di­tional and un­der-the-radar ways to help clients earn more af­ter taxes.

Financial Planning - - CONTENT - By Al­lan S. Roth

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.


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.

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