Q&A: Improving Tax Efficiency in Investor Portfolios

There’s a saying in investing: Don’t let the tax tail wag the investing dog. But it still hurts to share your investment gains with the IRS.

Many investors would rather sell some investments at a loss to offset their gains through tax-loss harvesting than give up all that money in taxes. But if you truly want to invest in a tax-efficient manner, think of tax-loss harvesting as an ongoing, year-round process.

We spoke with Paul Gamble, CEO of 55ip, a financial technology company that’s built a tax-smart investment strategy “engine” designed to help advisors create tailored investment portfolios at scale.

Financial advisors can improve client outcomes with a more tax-efficient approach, Gamble says. He shares the ways taxes create a hindrance to financial progress and how tax-loss harvesting opportunities should be monitored year-round. Here are edited excerpts from that interview.

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How can financial advisors overcome taxes as a barrier to financial progress?

Let’s start by getting specific about the barriers because they’re not all obvious. Taxes can certainly undermine financial security by eroding investment returns and wealth over time. But what’s less understood is that they also can discourage clients from updating their portfolios and potentially inflict financial damage when savings are turned into income later in life.

Through tax-loss harvesting, securities in a client portfolio that decline in value can be sold to realize a capital loss. Those securities can then be replaced with others that are just similar enough to play the same role, but sufficiently different so as not to trigger wash sale rules.

High-net-worth clients might have access to harvesting strategies throughout the year. But for most clients, tax-loss harvesting typically happens just once a year — if at all — through a manual process by their financial advisors.

After a decadelong bull market that’s resulted in widespread accumulated capital gains and equity-heavy portfolios, moving clients to updated portfolios that better reflect their risk tolerance and current needs can result in a hefty tax bill. As a result, many clients just don’t move at all, leaving them vulnerable from a market risk perspective. Financial advisors can overcome this particular barrier for clients through tax-smart transitions.

[Read: How Biden’s Tax Proposals May Impact Financial Advisors’ Clients.]

Why should tax-loss harvesting be monitored year-round?

From a client perspective, it’s about bigger impact. The more opportunities there are for tax-loss harvesting, the more the financial advisor can sell and replace losers in a client’s portfolio and maximize that yearlong tax savings figure.

The other big benefit is for the financial advisor. Manual tax-loss harvesting often takes a lot of effort, is less effective and creates risk of human error. By using automation, financial advisors can be more productive, freeing valuable time that they can use to work with their clients on meeting their goals.

What is a key trend you are watching related to tax-smart investing?

It’s hard to overstate how tax-smart transactions are a game changer for financial advisors and their clients. Many investors are approaching a comfortable retirement in large part due to the success of their portfolios. But at the same time, those portfolios are presenting challenges as investors enter the next phase of their lives.

Some have concentrated stock positions from long, successful careers with one company. Others might have investment portfolios that have done extremely well for them, but now their needs are changing, so they should change their portfolio to align better with their risk tolerance.

Many financial advisors are finding that they can achieve more consistent results across their client base by implementing some sort of model portfolio, whether of their own creation or designed by an institutional asset manager, offering more appropriate risk and diversification.

[READ: Q&A With Eve Cout of Blackrock on Model Portfolios.]

Converting retirement assets, such as individual retirement accounts, to these models is relatively easy as there are no tax consequences. But for those with substantial savings in taxable accounts, recognizing the taxable gains on those holdings that have served them so well is a tough pill to swallow.

Tax-smart transitions allow clients to manage the initial tax budget, even if that tax budget is $0, to make a defined amount of progress toward their target portfolio, and then capitalize on market volatility with year-round tax-loss harvesting to realize taxable losses that can offset additional gains from the transition. Instead of simply fearing what damage volatility might do to their savings, they can actually use the volatility to advance their investment objectives.

How can financial advisors optimize tax transitions based on client objectives?

Tax-smart transitions are more than simply spending a tax budget, investing what’s available in the new positions and then waiting for tax-loss harvesting opportunities to allow for recognition of further gains. A key aspect is optimizing the portfolio while it’s in transition to get the client as close as possible to their desired risk and return profile.

For example, if a client has concentrated, single stock positions in their initial holdings, they may overweight certain fixed income positions to balance that risk. Then they construct new parts of the portfolio to use the existing positions as complements in achieving the overall portfolio objectives.

Why should tax-smart investing be top of mind for financial advisors and their clients today?

Tax-smart investing may be the best opportunity available for financial advisors to help get their clients to the right portfolios, improve outcomes and make real financial progress in their lives.

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Q&A: Improving Tax Efficiency in Investor Portfolios originally appeared on usnews.com

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