With another Tax Day behind us, advisors and investors can be tempted to put tax management on the back burner. But just because tax-filing season is over doesn’t mean that there are no more opportunities this year for helping investors improve their after-tax portfolio outcomes.
The wealth management industry has spent years marketing tax management as a feature layered onto a portfolio after investment decisions have been made. Instead, it should be framed in the following way, to maximize the impact tax management can make – tax awareness is not merely an add-on feature, but a holistic overlay that should be embedded in every investment decision from the start.
This distinction matters because a service applied reactively can only do so much. But a service integrated into portfolio construction from the outset can systematically manage the realization of capital gains, coordinate across asset managers, and extend the holding periods of positions that would otherwise trigger avoidable short-term gains.
Advisors who consciously make the shift from tax management as a service to tax sensitivity as a design principle tend to generate more durable after-tax results for clients – not necessarily because they have better technology and resources, but because they are asking holistic, tax-aware questions early in the process, and they keep asking them throughout client relationships.
Recognizing Tax Management’s Differentiation Potential
Historically, many advisors that have marketed tax management as a service or feature have handled tax-loss harvesting service requests in December. Even though December is not the most opportune time to perform tax-loss harvesting, many advisory practices have undertaken it at that time to lock in losses before the tax year ends.
However, tax management encompasses so much more than tax-loss harvesting. It also includes gain-loss matching, retaining non-model positions, and gain deferrals. Many advisors already have the internal mechanisms and marketing materials in place for tax-loss harvesting, but they don’t typically have the capability to offer the other important elements of a holistic tax management approach. As a result, they would need to expand their existing tax management operations and resources in order to incorporate taxes more holistically into the design of their practices.
To do this effectively, advisors need to be thinking about tax management for a client prior to even obtaining that client. The initial conversation with a prospect should focus on the fact that the advisor will not just provide investment advice, but after-tax investment advice. The advisor should communicate that they are not just managing taxable accounts, but structuring the portfolios differently (using tools such as tax overlays and tax-managed direct indexing strategies) to maximize after-tax wealth.
How To Begin The Holistic Tax Conversation With Clients
There are plenty of yes/no or open-ended questions that advisors can ask clients to broach the subject of taxes during initial conversations in the prospect stage. Some advisors may feel intimidated by the tax subject because they feel they lack the necessary U.S. Tax Code expertise, but all they really need to show prospects and clients is that they are thinking about the after-tax wealth experience.
They can introduce tax management, and the holistic, proactive strategies they deploy throughout the year, with some simple questions to grab attention:
• When you’ve filed your taxes, have you ever been surprised by the amount of additional income you’ve generated through your investments? Have you ever been surprised by how much your investment portfolio contributes to your taxes?
• Have you ever been surprised when you have to write a check to the IRS because of mutual fund distributions?
• Do you want to obtain greater clarity into the amount of capital gains your portfolio generates every year, so you can better predict your tax exposure?
The simplest question to ask at the outset of a client relationship is, “What tax bracket are you in?” In my experience, the natural response from clients is often, “Why do you ask?” That opens up the opportunity for advisors to explain how capital gains can undermine after-tax performance, and how their approaches can help clients keep more of what they make.
Another simple question: “Would you like to pay more tax instead of less tax?”
To show clients how they can help them make the “less” answer a reality, and demonstrate that they do so by looking at a client’s entire financial picture, advisors can ask, when reviewing accounts, “Do you have other investment accounts or assets held elsewhere, and if so, do you know what they contribute in terms of realized gains?” This is where advisors can demonstrate greater value, and deepen trust, by showing clients tax exposure across their overall financial pictures.
How To Effectively Incorporate Tax Management Into All Taxable Accounts
Being “tax-sensitive” or “tax-aware” involves more than just allocating a client’s fixed income to a municipal manager instead of a taxable manager. That helps, but to truly improve a client’s after-tax investment and wealth outcomes, an advisor has to look at the client’s entire taxable portfolio, and think of taxes as something client-level, rather than account-level.
After all, accounts don’t pay taxes – investors do. That’s one of the first steps to elevating holistic tax management to a central aspect of their advisory practices.
The Biggest Changes Advisors Can Make Now
The most scalable way for advisors to incorporate tax management into all taxable accounts is to outsource the tax management of those accounts to a WealthTech provider with comprehensive holistic tax overlay services. If advisors invest in technology solutions that they use themselves, that leaves less time for them to have holistic wealth management conversations with clients, or engage directly with clients on other value-added matters.
However, the common obstacle to outsourcing holistic tax management is that many advisors are worried about giving up control of security selection. While this concern stems from a well-meaning dedication to clients and advisory practice value, it misses the big picture. What clients care about most is the amount of capital-gain realization taking place in their accounts – not which specific security is creating that capital gain.
A holistic tax overlay offering can allow advisors to set a hard and fast tax budget that can dictate the amount of gains each client realizes. An overlay service will also determine which specific securities and tax lots to sell in order to minimize portfolio risk, while adhering to the client’s set capital-gains guidelines.
In order to provide a comprehensive and holistic tax overlay for their clients, the best thing advisors can do is give up that control over security selection, so they can outsource tax overlay operations to a direct indexing manager or a provider of holistic tax overlay services.
The growth in available tax-smart solutions in today’s wealth management marketplace has increased discussion about tax management – prompting advisors to become more comfortable incorporating this differentiator into their value propositions. Taxes are something that advisors and their clients should be thinking about all year long, not just in the lead-up to April 15.
When advisors take steps to incorporate tax management into their holistic wealth management offerings, as a proactive strategy for all taxable accounts instead of merely an optional service, they can help clients and their families keep more of what they earn. That is something you can’t put a price tag on, and inspires stronger client loyalty across generations.
Erik Preus, CFA, is group head at Investment Solutions at Envestnet.
