Avoiding the capital gains tax trap when making portfolio changes

When advisors make changes to a client's portfolio, they can inadvertently trigger a tax event and it’s a common occurrence according to Erik Preus, group head of investment solutions at Envestnet.

"There are several common scenarios, and they’re all typically associated with portfolio changes," he tells InvestmentNews, adding that this can often happen when a financial advisor takes on a new client who expects portfolio updates.

"If the advisor isn’t careful about looking for unrealized gains or losses in the new client’s portfolio, then short-term capital gains could be triggered when they make those portfolio updates,” he says.

Preus also points to other situations that can lead to the same outcome, such as when "an advisor is working with an external money manager, and the manager is focused on its own model portfolio but may not be able to tell whether or not an individual client invested in the models has unrealized short-term capital gains” or when an advisor is changing the risk profile for a client or allocating from equities to fixed income.

Preus does not consider the triggering of short-term capital gains as an investment management error, but an outcome, and says sometimes it can be necessary "to get out of a position that a manager believes is going to blow up, and absorb the short-term consequences, than lose all of a holding’s value by staying in that position."

Regarding which clients are most susceptible to the "short-term tax trap," Preus points to "any high-net-worth investor with a sizable portfolio of equity securities." The most critical factor, he notes, is the individual's income tax bracket, since "short-term capital gains are taxed at an individual’s income tax rate."

After-tax performance reports

He suggests that using an after-tax benefits report can be a useful tool by providing various metrics such as the actual performance impact on an account after taxes compared to a scenario without tax overlay strategies.

“This type of report helps quantify the investment impact of short-term capital gains and illustrates the likely after-tax consequences of disabling tax overlay services, often expressed in terms of real-dollar returns,” he says.

Tax overlay accounts, such as Envestnet’s own, can meet the objective to eliminate short-term capital gains and manage accounts according to the long-term capital gains budget crafted for each client.

“When reviewing after-tax reports across a broad set of accounts, the data consistently shows positive after-tax alpha associated with the reduction of short-term capital gains. This suggests that minimizing short-term gains can have a favorable impact on portfolio performance from an after-tax perspective,” Preus says.

Balancing tax efficiency with other objectives, such as risk management, is a key consideration and Preus suggests a framework that helps advisors and clients make informed decisions.

"A tax analysis that shows the performance risk relative to the target model of implementing various taxable gains budgets into a portfolio can demonstrate the tradeoff for the advisor in various scenarios," he says. "By presenting various illustrations, this can help the advisor work with their client to make the appropriate decision about their account’s taxable gains budget, and what the associated risk might be for that budget."

When discussing tax-smart portfolio management with clients, Preus believes a single metric is most effective.

"I would say the most important metric is just that hard and fast taxable gains budget," he notes. "The taxable gains budget helps provide that clarity to investors on what they are likely going to have to pay next April, and plan ahead.”

Standing out

According to Preus, tax management is a powerful differentiator for advisors.

"Despite the fact that tax management is receiving a lot of attention, the majority of advisors are still not paying enough attention to after-tax performance for their clients," he explains. "Survey after survey tells us that tax management is one of the most important concerns in the minds of end investors, but most investors don’t think their advisors are spending enough time on it. So there’s a disconnect between investor expectations and what advisors are delivering and if advisors are able to deliver after-tax performance insights to investors, they can successfully differentiate themselves from much of their competition."

Preus says that advisors must be careful not to overreact in volatile markets, particularly when it comes to loss harvesting.

 "One of the things that we see is that oftentimes, when you have a steep market decline, advisors want to harvest as many losses as they possibly can," he says.

But he warns of two significant downsides. Firstly, if advisors reinvest in an ETF, they may be harvesting at a market low, which could lead to a material unrealized gain as the market snaps back. The other risk is staying in cash and missing the market recovery.

"Advisors need to be mindful of these unintended consequences from harvesting losses just because of a slide into a down market,” he warns.

While the current tax environment appears stable, Preus advises advisors to remain vigilant about future changes and suggests keeping a close eye on what both major political parties propose regarding "capital-gains tax rates." He stresses that "whenever there is any change in administration, advisors should look carefully at the new administration’s tax proposals, and determine how, if implemented, they would affect their client accounts."