Portfolio Perspectives: Optimal Asset Location, Part I – Equities

February 9, 2024

The Right Asset. In the Right Place. At the Right Time.

By Lucas Felbel, CIMA®

Director, Portfolio Services

In the ever-evolving landscape of wealth management, financial advisors navigate the difficult inevitabilities of death and taxes with their clients. While the former remains beyond our control, the latter offers a subject where advisors can exert positive influence on their clients. The strategic placement of assets in specific accounts for the right reasons can significantly enhance after-tax returns—a crucial aspect of effective financial planning.

Wealth managers grapple with the intricate task of balancing client returns, aligning them with financial goals and navigating the complex arena of taxes. A direct way to impact after-tax returns is the deliberate allocation of assets across taxable, tax-deferred, and tax-exempt accounts. In this installment of Portfolio Perspectives, we delve into the nuanced world of equity asset location and explore scenarios where intentional asset placement can optimize outcomes for clients.

Equities Location: A Tailored Approach

There is no one-size-fits-all solution to asset location, and the answer to the perennial question, “What is the best approach?” often elicits everyone’s least-favorite response: It depends. In the realm of taxation, Dynamic operates with a keen awareness when managing client portfolios, emphasizing the importance of consulting with tax experts before implementing specific recommendations.

ETFs vs. Mutual Funds: Tax Efficiency Unveiled

ETFs have emerged as one of the most prolific tax-efficient investment vehicles. This is in comparison to mutual funds which may burden investors with taxable income at inopportune times through their periodic passing-on of capital gains. The structure of ETFs is such that capital gains distributions are not as prevalent as with mutual funds. The timing of mutual fund capital gains distributions in taxable accounts, especially late in the year, can complicate tax situations and hinder financial plans.

Mutual funds, especially actively managed funds with higher turnover (more on this later), pass on capital gains that are realized through the management of the fund to shareholders. This makes mutual funds generally better placed in tax-deferred and tax-exempt accounts. The inherent tax efficiency of ETFs is a key driver in Dynamic’s shift towards ETF models for managed accounts.

Actively Managed Funds vs. Indexed Funds: Navigating Turnover

Actively managed funds trade more frequently than indexed funds with the goal of surpassing benchmark returns. Funds that are actively managed pass the cost of capital gains on to their shareholders. This is especially prevalent for mutual funds, but can be experienced with ETFs employing currency hedging, options, or other derivative-incorporating strategies. This increased underlying position turnover results in increased taxable income distributions to clients.

In contrast, indexed funds that faithfully and passively track their benchmark boast lower turnover, mitigating unwelcome tax implications. Advisors may strategically place actively traded funds in tax-deferred and tax-exempt accounts, reserving taxable accounts for lower-turnover index funds.

Bonus Tip: Be on the lookout for mutual funds with “tax advantaged” in their name. These funds aim to minimize income and capital gains distributions and therefore, may be a good fit for taxable account placement after careful due diligence.

Individual Equities: A Strategic Dance

  • Growth Companies: Taxable accounts can prove advantageous for individual stocks, particularly in the growth category, as they typically generate minimal dividends that are taxed as income to shareholders.
  • Value Companies: Investors in higher tax brackets should exercise caution with value-classified companies due to their associated dividend income. Value companies offer higher dividend yields to compensate for the elevated investment risk and may find a better home in tax-deferred or tax-exempt accounts.
  • Increased Oversight: Holding individual company shares provides greater control over taxable outcomes vs. certain types of funds, particularly for growth companies where, rather than at a fund company’s discretion, most taxable events materialize upon sale at the direction of the advisor or client at the time of their choosing.
  • For Retirees: Considering Required Minimum Distributions (RMDs) and their taxation at ordinary income levels, holding individual stocks long-term in taxable accounts may mitigate future tax liability. This offers the advisor and client increased control over the timing and number of taxable gains realized when considering the whole client portfolio.

Bonus Tip: Combine long-term holding periods on taxable positions with Qualified Charitable Distributions (QCDs) to further increase tax savings.

  • Estate Planning: Taxable accounts housing low-basis individual stocks may align with specific estate planning goals, ensuring a step-up in basis for the next generation. This could erase potential tax burdens for the recipient and increase overall tax flexibility for the redistribution and diversification of family wealth.
  • Charitable Donations: Leveraging low-basis individual stock positions in taxable accounts for charitable donations can yield double tax relief; the client eliminates the unrealized capital gain and resulting tax burden, AND the client receives an immediate tax benefit at the asset’s current value at donation. This approach requires careful consideration with clients and consultation with accounting representation. Custodian-offered Donor Advised Funds are a common, cost-effective way to consider charitable contributions for client portfolios.
  • Qualified Dividend Income: While tax-deferred or tax-exempt accounts typically host high-income securities, certain situations may warrant placing qualified dividend-paying stocks in taxable accounts. Qualified dividends are taxed at lower income rates and may be suitable for specific client situations. Contrast this with the earlier section regarding dividend-paying stocks in taxable accounts, further highlighting how every client scenario is different.
  • Tax-Loss Harvesting: Strategically harvesting unrealized losses from equity positions provides flexibility offsetting capital gains. Realized losses can be used to reduce portfolio concentration risk, align with a tax-conscious portfolio transition strategy, and maintain or increase client asset allocation diversification levels within a tax budget. Tax-loss harvesting can be accomplished ad hoc on certain client positions, or by using a specialized separately managed account (SMA), like Dynamic Custom Indexing.

Bonus Tip: Realized capital losses should be framed by advisors to clients as a flexible asset to be redistributed for the betterment of overall portfolio goals. See a previous Portfolio Perspectives on how to approach this conversation with clients.

Art and Science in Asset Location

Asset location optimization is a multifaceted, complex endeavor with no definitive answers for individual client situations. This exploration into equities allocation merely scratches the surface of the myriad scenarios.

The lack of a clear answers for asset location questions can be intimidating for advisors. This opaqueness can be alleviated by conducting thorough discovery sessions with clients before individual investments are considered. When advisors intentionally ask the right questions of clients, they begin to unravel the intricacies of asset location and provide impactful benefits to their clients.

Invest with intention.

This article is not exhaustive, and specific advice should be sought from qualified tax professionals before implementation.

For more Dynamic Portfolio Perspectives, check out “Navigating HNW Challenges? SMA It Ain’t So”

For more information, contact Dynamic’s Investment Management team at (877) 257-3840, ext. 4 or investmentmanagement@dynamicadvisorsolutions.com.

As Director, Portfolio Services, Lucas Felbel, CIMA®, leads the implementation, monitoring and evaluation of trading activities at Dynamic Advisor Solutions.

Disclosures

This commentary is provided for informational and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. This is not intended to be used as a general guide to investing, or as a source of any specific recommendation, and it makes no implied or expressed recommendations concerning the manner in which clients’ accounts should or would be handled, as appropriate strategies depend on the client’s specific objectives.

This commentary is not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investors should not assume that investments in any security, asset class, sector, market, or strategy discussed herein will be profitable and no representations are made that clients will be able to achieve a certain level of performance, or avoid loss.

All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed as to its accuracy or reliability. These materials do not purport to contain all the relevant information that investors may wish to consider in making investment decisions and is not intended to be a substitute for exercising independent judgment. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements or assumptions are now or will prove to be accurate or complete in any way.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.

Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor.

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