Five obstacles to true tax optimization

Advisers need to understand how tax strategies affect the portfolio, and how assumptions differ from reality.

As we approach year end, tax considerations bubble up to the top of the portfolio management agenda for advisers.

As they weigh tax benefit claims made by competing managers, the cynicism and confusion around the claims made is real. There are over $7.5 trillion in tax-dependent assets under management in the U.S. that advisers can manage better by understanding the drivers of tax optimization benefits.

After-tax returns depend on pre-tax performance and taxes paid. Short -term tax rates are higher than long term rates. Tax optimization begins by minimizing realized short-term gains and setting up investors to have long-term gains. Portfolio rebalancing that is aware of this feature can actively realize short-term losses (or avoid short-term gains) and help decrease the taxable gains for an investor.

(More: How investors can leverage tax alpha to increase returns and savings)

Here are five common aspects that affect the reported benefits of tax optimization:

1. Know your rate relative to what is being used to report the tax benefits.

To calculate or simulate savings, it is critical to know the difference between short-term and long-term tax rates. Most investment managers report tax benefits while assuming that clients are at, or near, the maximum tax rate, which equates to maximum reported gain.

For example, among two popular robo-advisers focused on retail clients, the assumptions for the difference in tax rates are 18% (Wealthfront) and 15.8% (Betterment). So all else being equal (which it is not), Wealthfront would report numbers that are ~15% higher than Betterment for an investor who has to use the same tax differential regardless of their choice of robo-adviser.

Consider your client’s income, marital status, state and local gains taxes to adjust the reported tax benefits.

2. Omitting any discussion of impact to pre-tax returns, which overstates tax benefits and how it is defined.

Tax rates matter. Equally importantly, so do pre-tax returns. When client accounts incorporate tax optimization, they incur higher trading costs and end up with a portfolio that is different from one without tax optimization. The wash sales rule ensures that selling to generate short-term losses affects portfolios because what you sell and what you replace it with cannot be identical.

The resulting portfolio can drift away from the intended exposures. Most firms and simulations do not discuss trading fees and such portfolio drift, which can change pre-tax performance and lead to substantial trading costs, especially for smaller accounts. Advisers should learn about the differences in their pre-tax returns due to tax optimization, and make sure that the reported “tax alpha” accounts for and specifically penalizes a loss in pre-tax returns.

3. Assumption of no year-end drop in assets due to taxes paid that overstates the pre-tax performance of a portfolio.

Reporting of these tax benefits can have other issues as well. When tax-loss selling takes place, the client’s tax spend is optimized, not eliminated. Taxes are still paid. Technically this reduces the portfolio value by the amount of the tax paid.

Some tax simulations are opaque about accounting for a drop in the portfolio assets at yearend despite taxes being paid. Clearly, omitting this reduction from the portfolio will result in some over-statement of wealth in tested results since what is due to the IRS is now being compounded over time as investor wealth.

4. Assumption that new assets are added regularly, which can overstate tax gains in an upward trending market.

Another assumption used in reporting is that clients will regularly—often quarterly—add assets to the portfolio. This means there is a steady flow of new short-term positions to optimize. Often these numbers may not represent portfolio choices since these assumptions are derived from behaviors seen in 401K and employee benefit programs.

5. Use of selective time periods to inflate potential tax benefits.

The power of tax optimization also varies widely depending on the years being studied. Time periods with very weak portfolio performance followed by gains, allow for large loss harvests that are used to offset future gains. Data-mined time frames can create an elevated expectation of the benefits of tax optimization.

Dr. Vinay Nair is the founder and chairman of 55ip.