How to Manage a Tax-Conscious Portfolio

By Ellen Sheng September 14, 2020

This is Part 1 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients manage the tax impacts of their portfolios.

Death and taxes may be inevitable, but just as people look after their health to prolong their lives, advisors can minimize the impact of taxes to maximize clients’ earnings.  

If anything, advisors say tax management has become more critical than ever. As investing and portfolio construction become more commoditized — thanks to the rise of robo-advisors — creating a customized tax-conscious portfolio is one area where advisors can shine. 

“We can add more value in financial planning and tax work than we can on investments,” says Chris Benson, principal at LK Benson & Co., a fee-only financial planning firm.

That’s because, unlike most other factors that advisors take into consideration, taxes are one area that advisors actually can control. 

“We can’t predict consistently what the economy is going to do in the next six to 12 months, what GDP [gross domestic product] will be, what inflation will be, where interest rates are going, what earnings growth may or may not be,” says John Bussel, chief investment officer at advisory firm Team Hewins.

“But we can control things like tax efficiency very well and how much turnover and short-term managers have in their portfolios or how much taxable income a portfolio may generate,” he adds.

Initial homework  

To manage a portfolio that’s as tax efficient as possible, experts say it’s crucial to put tax consciousness at the center of every investment decision. When working with new clients and learning more about their overall situation, advisors should consider the clients’ income and tax bracket, as well as taxable and non-taxable accounts. It’s also important to understand their goals and risk tolerance. 

These pieces all come together to create the target asset allocation — an essential building block when crafting portfolios. But while asset allocation is often the focus, it’s only part of the picture, says Benson. The other critical consideration is the tax impact. 

Asset location and other tools 

To maximize the tax efficiency of a portfolio, advisors split investments among tax-free, tax-deferred and taxable accounts. 

Taxable accounts, such as brokerage accounts, hold the most tax-efficient investments, usually municipal bonds, Treasurys, individual stocks that are held for at least a year, and stock funds with low turnover, such as exchange-traded funds. Corporate treasury bonds, which are taxed as ordinary income, can be moved to tax-deferred accounts, as can real estate investment trusts. 

Advisors also take advantage of other tools such as tax-loss harvesting and deferral strategies such as Roth individual retirement account conversions.

Charitable giving is another tool for lowering clients’ tax burden. Recent tax changes that doubled the standard deduction, which raised the hurdle to itemize deductions, have pushed more clients to bunch up charitable giving. By bundling, say, five years of charitable giving into one year, clients can take the itemized deduction in one year. A favored tool for doing this is through a donor-advised fund. 

“It can be scary and unnerving to part with such a large number,” Benson acknowledges.

But clients who do this in their prime earning years are successfully playing the tax arbitrage game and get the most “bang for the buck” by giving when they are making more and in a higher tax bracket, he says. 

Gifting assets with a low-cost basis is another approach, as are cash gifts. Under the Coronavirus Aid, Relief, and Economic Security Act, the maximum deduction on cash gifts is 100% of adjusted gross income it’s typically up to 60%. To maximize efficiency from a tax perspective, advisors should review the timing of such gifts. Charitable giving and charitable deductions require a customized approach as clients can have widely varying goals. 

Whatever tools or strategies advisors use, it’s important to go back to tax management regularly.

“It’s all-encompassing. It’s not one of those things where you sit down and say, ’We will tackle tax planning in September,’” says Benson. “It’s one of those topics that, frankly, you need to discuss at every meeting and be really abreast of all the changes.”

Next: Using Tax-Advantaged Bonds in Times of Low Yield