Tax Planning

An adviser's touch can improve tax aware investing

Robo-advisers can miss key details when planning for high-net-worth investors

Jun 19, 2015 @ 12:06 pm

By Rey Santodomingo

Robo-adviser services are programmed to recognize the importance of investing with an eye toward maximizing after-tax returns, but may miss the nuances around high-net-worth clients' needs.

These online investment services can work well to provide investors access to diversified portfolios composed of ETFs, and most also offer the added service of tax-loss harvesting of those ETFs. But, while the online options available may be great for investors with relatively simple tax situations and portfolios, affluent investors are often better served by an adviser who has the ability to tailor a strategy for their unique situation.

Affluent investors often have a wide range of existing investments including low cost-basis stock, stock options, hedge fund holdings and actively managed separate accounts. On the tax side, affluent investors may be subject to the alternative minimum tax, the unearned income Medicare contribution tax or the phaseout of itemized deductions. Advisers have access to more tools to build strategies around existing investments while taking into account the investor's unique tax situation than the online investment service does.


One of the most powerful tax management tools at the adviser's disposal is the separately managed account. While ETFs provide effective diversified exposure to the market, separately managed accounts can be customized to address the specific needs of affluent investors more effectively in terms of account transitions, managing concentrated or low-basis positions, charitable gifts and future tax planning.

A common use for a tax-managed separate account is the transition of an existing portfolio of stocks to an index-based strategy. To invest in an ETF portfolio, clients must completely liquidate their existing portfolio, which can result in a large tax cost. An adviser using a tax-managed separate account can help the client make this transition gradually at a lower tax cost.

Tax aware investment managers keep the securities in the existing portfolio that overlap with the index, and sell out of securities held at a loss to mitigate the realization of capital gains. A tax aware manager can prepare a set of potential strategies of varying tax costs for the adviser to review with their client. After the initial transition, the portfolio can be systematically loss harvested or the transition can be accelerated in order to reduce tracking error. Through ongoing discussions with the client with regard to tracking error and tax cost, the adviser can help the client make the transition over time.


Concentrated stock positions present another opportunity for advisers to improve investment outcomes using tax-managed accounts. Some investors with concentrated stock positions may use an online investment service to gradually build a diversified portfolio. However, buying an index ETF which invests in the same stock, industry and sector as the concentrated stock position can be counterproductive in terms of increasing diversification.

Instead, an adviser can help their client design a custom tax-managed account that reduces overlap with their concentrated stock holding by excluding the stock, industry or sector, thereby improving the client's overall diversification. A careful analysis of correlation is required to select the proper exclusion. The tax-managed account is structured to provide the added benefit of using any harvested losses to help offset the gains associated with trimming concentrated stock positions. An adviser's oversight over the client's overall realized capital gains/losses can help match harvested losses with gains realized by selling stock.

Tax managed accounts also create opportunities for advisers to help investors who have charitable-gifting goals. One sign of success of the tax management process is the presence of highly appreciated securities. Typically, loss harvesting reduces the cost basis of the portfolio and results in low cost basis, highly appreciated securities. Alongside the adviser, the tax aware investment manager can help select the mix of securities that optimally reduces the embedded tax burden while satisfying the charitable- gifting goal and steering clear of charitable-gifting limits.

For some investors, it can pay off to realize gains in a tax-managed separate account ahead of a tax rate increase, or to reset the cost basis of the portfolio for future loss harvesting. Assuming the highest marginal federal tax rates, with this approach investors selectively pay taxes on long-term gains at 23.8% now to increase opportunities for short-term capital losses valuated at the 43.4% rate. Working with advisers, clients can decide how quickly to realize long-term gains.

Online investment services deliver a certain level of tax management through harvesting ETFs and are appropriate for many investors, however advisers have the ability to deliver more customized alternatives.

Rey Santodomingo is the director of investment strategy at Parametric Portfolio Associates, a registered investment adviser.


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