By Marina Hernandez, CFP®, EA, Founder & CEO
Marina Hernandez, CFP®, EA
Swiss American Wealth Advisors
Taxes are one of the biggest drags on investment returns. As the saying goes, “It’s not how much you make, it’s how much you keep,” that matters.
If we ignore tax-efficient Investment management, no matter how well diversified and low cost our clients’ investment portfolios may be, our clients will need to work harder, longer—or both—to meet their financial goals.
How can we, as financial advisors, help our clients reduce the tax bite?
Understanding three key aspects of a clients’ profile can help us design personalized tax-efficient investment strategies that generate tax alpha for our clients. Here, we’ll explore each one:
- Income tax bracket
- Legacy and charitable inclinations
- Outside assets and sources of income
How do client income tax brackets matter?
Due to different income floors and ceilings that limit access to tax benefits or result in surtaxes, an additional dollar of income can sometimes cause more than one dollar in additional taxes.
You read that right!
An extra dollar of taxable investment income earned could lower our clients’ after-tax income.
Client tax-bracket management is therefore a critical aspect of tax alpha. Careful tax-bracket management can reduce or avoid net investment income tax (NIIT); maximize tax credits such as the child tax credit, dependent care credit, premium tax credit, education credits and others; and minimize the tax impact on Social Security benefits and the cost of Medicare by avoiding IRMAA.
Strategies that can be used to manage tax brackets include:
- Tax-loss harvesting: Investors can use capital losses to offset capital gains and reduce their ordinary income by up to $3,000 a year when capital losses exceed gains. For a client in the highest tax bracket in California, this could result in $1,623 or 54.1%, tax reduction between federal, state and NIIT tax. Unused net capital losses can be carried forward to future years to provide additional capital gains and ordinary income reductions.
- Capital gains harvesting: This can be counter-intuitive, but in certain circumstances, clients can benefit from accelerating the realization of capital gains. In 2023, long term capital gains are taxed at 0% rate when taxable income is less than $44,625 for single filers or $89,250 for married couples filing jointly. For clients at those income levels, capital gain harvesting is a no-brainer. Clients just starting their careers, or taking a sabbatical, or going through job transitions can find themselves in lower than otherwise tax brackets providing these opportunities.
- Tax diversification: Not all investment accounts are taxed equally. Accounts such as 401(k)s, 403(b)s and contributory IRAs allow current tax deductions for contributions and tax deferral of current earnings in exchange for ordinary income taxation and required minimum distributions in the future. Others, like Roth IRAs, Roth 401(k)s or 529 accounts, provide no current or a limited state income tax deduction, but allow tax-free distributions of contributions and accrued earnings.
Brokerage accounts provide no tax deduction for contributions and no tax deferral for accrued earnings but are eligible for preferential tax treatment under the qualified dividend, tax-free municipal interest and long-term capital gains rules. And finally, Health Savings Accounts (HSAs), can provide the best of all worlds by allowing tax deductible contributions, tax deferral of accrued earnings and potential tax-free distributions of both contributions and earnings. Creating a personalized plan that builds client wealth across multiple types of accounts provides clients tax flexibility at retirement and opens the door for additional tax alpha during wealth accumulation.
- Asset location optimization: Matching investment tax attributes with accounts tax attributes can improve tax alpha exponentially. For example, the relative inefficiency of certain investments taxed at ordinary rates such as interest, ordinary dividends and short-term capital gains can be reduced or eliminated by placing investments generating those types of income in tax-deferred or tax-free accounts.
Investments that receive preferential tax treatment such as tax-free interest, qualified dividends and long-term capital gains are most valuable when located in taxable accounts such as brokerage accounts. Investments with the highest growth potential should be placed whenever possible in Roth accounts, where the expected high growth could never be taxed.
How do client legacy and charitable profiles matter?
Understanding client legacy values and charitable intent can help us integrate their estate and charitable planning with their investment strategy to maximize the after-tax impact of their giving strategies.
Examples of tax-efficient investment strategies that can supercharge client estate and charitable goals include:
- Donor-advised funds (DAFs): These funds allow donors to make a large charitable contribution today, receive an immediate tax deduction and direct the contributions to their preferred charities over time through recommended grants. DAFs allow contributions of appreciated investment positions with the double benefit of the charitable deduction and the permanent avoidance of capital gains on the appreciation. When made in high income years using appreciated positions that would otherwise be sold during portfolio rebalancing, this strategy also increases the tax-efficiency of investment administration and provides additional opportunities for tax-bracket management.
- Direct indexing: Clients may own accounts from which they don’t intend to take distributions because they’re intended to be passed on to their heirs or are earmarked to fund a testamentary trust, for example. Direct indexing, a personalized portfolio of individual securities, can be ideal for such accounts by automatically harvesting individual security tax losses. Capital losses accumulate for the clients’ benefit and their heirs and testamentary trusts benefit from the step up in cost basis when they receive the bequest, fully avoiding capital gains tax.
How do client outside assets and sources of income matter?
It’s not just the after-tax return on the accounts we manage that matter. It’s our clients’ overall after-tax returns that matter.
Applying a tax-efficient investment strategy that takes a client’s outside assets and income into consideration can improve their after-tax returns too, even when we don’t manage those assets.
Helpful strategies to consider include:
- Using tax loss harvesting or daily tax loss harvesting to accumulate capital losses can offset future large capital gains resulting from: the sale of the client’s business at retirement; the exercise of certain stock options or restricted stock awards; or diversifying away from a highly appreciated, concentrated stock position.
- Increasing clients’ tax diversification through Roth conversions, backdoor Roth conversions, or mega backdoor Roth conversions when available should increase clients’ future share of tax-free income.
- DAFs can also be used to help diversify away from concentrated appreciated stock positions, or to transition new client portfolios tax efficiently.
As financial advisors, we have the power to add significant tax alpha to our clients’ portfolios through tax-efficient investment management. By managing our client’s tax brackets, considering their legacy and charitable goals, as well as their outside income and assets, we can create customized strategies that help them keep more of their hard-earned money. As Benjamin Franklin famously said:
“In this world, nothing can be said to be certain, except death and taxes.”
With tax-efficient investment management, we can at least reduce the impact of one of those certainties for our clients!
Marina Hernandez, CFP®, EA, is an Investment Advisor Representative with Dynamic Wealth Advisors dba Swiss American Wealth Advisors. All investment advisory services are offered through Dynamic Wealth Advisors.