How Advisors Can Use Tax-Smart Separately Managed Accounts

One of the many ways that financial advisors can add value to their clients is by helping them reduce their overall tax bill when it comes to investing. Separately managed accounts, or SMAs, provide a platform for advisors to help their clients invest in tax-smart strategies in an efficient and low-cost way.

Separately managed accounts give advisors the option to build customized portfolios for their clients, while providing tax optimization, cost-efficiency and transparency. Before you consider whether SMAs are a good fit for your clients, consider the following:

— How separately managed accounts work.

— Tax benefits of separately managed accounts.

— What type of client should consider SMAs.

— Advantages of SMAs.

— Disadvantages of SMAs.

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How Separately Managed Accounts Work

SMAs are professionally managed investment portfolios, similar to exchanged-traded funds, or ETFs, and mutual funds. However, there are some key differences. With an SMA, the client owns the securities in the portfolio directly, which provides them with more control, since they have input as to what is owned and how it is managed. This provides clients with a much higher level of customization. For example, a client can choose to stay away from specific individual securities or a sector or industry overall, which allows them to align their investments with their values or avoid overconcentration in one stock or sector.

Tax Benefits of Separately Managed Accounts

Financial advisors can use SMAs to increase their clients’ “tax alpha,” which is generated by using tax-optimization strategies to increase the after-tax return of the portfolio. One way of achieving this is by reducing the amount of capital gains generated by a portfolio. SMAs provide tax-loss harvesting opportunities, which allow the investor to offset capital gains from one investment by taking advantage of tax losses in another investment. This strategy allows the client to sell an investment at a loss and then purchase another investment with similar characteristics, allowing the portfolio to stay in line with the clients’ objectives while generating a tax loss. This allows the client to avoid the wash sale rule, which does not allow an investor to claim a loss if an investment is sold at a loss and then repurchased within 30 days.

[READ: How to Use a Client’s Tax Return to Map Financial Success]

Another strategy that can be implemented with SMAs is deferring gains of highly appreciated securities already owned by the client. Instead of selling the securities to invest in a new portfolio, these can be transferred to an SMA and sold strategically, allowing a tax-smart transitioning of existing holdings. Instead of doing manual tax-loss harvesting at the end of the year, SMAs monitor holdings as frequent as daily in order to take advantage of tax-saving opportunities throughout the year.

SMAs also help manage tax rates by limiting short-term capital gains and non-qualified dividends. This strategy helps reduce any earnings that can be taxed at higher rates.

What Type of Client Should Consider SMAs?

SMAs are not for everyone, and advisors should consider certain factors before recommending them. SMAs may be a good fit for the following clients:

— Clients in a high tax bracket.

— Clients who have a high concentration in an individual security or industry.

— Clients who own significantly appreciated securities.

— Clients who require more investment customization.

— Clients with a sizable taxable investment account to meet minimum investment requirements of SMAs.

— Clients with an upcoming major tax event, like selling a business or appreciated company stock.

[READ: Tax Planning for High-Net-Worth Individuals]

Advantages of SMAs

SMAs provide a wide range of benefits in addition to tax optimization. Customization is at the top of these benefits. Portfolios can be built specifically tailored to a client’s needs, providing a variety of ways to satisfy a client’s wishes. Clients can choose to exclude any individual security or sector, such as tobacco, alcohol and weapons, or a stock already owned elsewhere, such as company stock.

A client can also wish to include specific securities or sectors. A client who wishes to align their investments with their values can choose to invest in companies that have an environmental or social impact that the client believes in.

Another benefit is cost efficiency. Although fees vary by the different investments and asset classes, SMAs typically have lower fees than actively managed mutual funds.

Disadvantages of SMAs

Although SMAs provide a wide range of benefits, there are some drawbacks that financial advisors should consider. One of these disadvantages is the minimum amount required to invest. Initial minimum investments typically range from $50,000 to $250,000 or higher. Although there are providers that offer lower minimums, the tax benefits are not as significant in smaller accounts, which is why these are typically offered to high-net-worth investors.

Although customization can be seen as a plus to many, it is a disadvantage for investors who prefer a more passive “set it and forget it” type of approach. Investing via SMAs is more involved due to their high level of customization and may not be a good fit for someone that does not want to play an active role in the investment of their portfolio.

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