When providing advice and managing investments, cutting clients' tax liabilities is of extreme importance. In fact, these days, it's even more important than ever because: clients hate paying taxes; robo-advisers claim to save investors lots of money on taxes; adding "alpha" by beating indexes is almost impossible; and clients are becoming more aware of the benefits of tax-efficient investing.
Some strategies create permanent tax savings, like avoiding short-term gains, while others merely postpone tax, like harvesting tax losses or selecting high-cost lot identification instead of average cost. Permanent savings strategies would seem to be of higher value than postponing tax because the latter requires "paying the piper" in the future. However, I would argue that postponing tax is at least as important as avoiding tax.
Investors will essentially hold up to three types of investment accounts: taxable, tax-deferred and non-taxable.
Taxable accounts will be subject to current taxation when income is received, in the form of interest or dividends, and when assets are sold at a gain. Tax-deferred accounts, such as IRAs, annuities and other retirement plans, will only incur tax when amounts are withdrawn. Finally, non-taxable accounts, like Roth IRAs, are never subject to tax.
When looking at the ultimate tax implications of each type of account, the following rules apply:
• Taxable accounts: Ordinary or capital gain tax will apply as income is received. Capital gains tax will apply if assets are sold at a gain. If assets are held until death, the tax basis is "stepped up" and nobody (including heirs) pays tax on the accumulated appreciation.
• Tax-deferred accounts: No tax will be incurred as income is received or transactions are made within a tax-deferred account. However, as funds are withdrawn, ordinary tax will be due on the growth and principal (to the extent a deduction was claimed on contribution). If a tax-deferred account is inherited by a beneficiary, ordinary tax will still apply. In other words, the tax liability does not go away, even upon death.
• Non-taxable accounts: No tax ever applies – even to heirs.
Theoretically, it could be possible to avoid tax on both taxable and non-taxable accounts. In order to [substantially] avoid tax on taxable accounts – gains would need to be postponed throughout the investor's lifetime – and interest and dividends would need to be minimized. Additionally, this tactic could only be possible if the investments are not completely used up during the investor's lifetime. Through ongoing tax postponement, temporary savings could be converted to permanent savings.
If avoiding tax is the ultimate goal, then, especially as clients get older, care should be taken to avoid taxable gain recognition at all times. Even if the asset allocation is not balanced, it might be worth some diversion from the model if rebalancing will result in gain recognition. Of course, tax-loss harvesting (and the zero capital gain rate, if applicable) can provide some flexibility to recognize gains without triggering tax.
Contrary to popular belief, it might be better to take additional cash needs from a tax-deferred account rather than recognize gain in a taxable account. Why? Because the tax-deferred account will be subject to tax no matter what. Taking a taxable distribution (beyond the
required minimum distribution) – especially when the investor's tax bracket is less than or equal to that of the heirs – allows the accumulated appreciation in the taxable account to permanently avoid tax.
Implementing a comprehensive tax-postponement strategy must be personalized based on each individual client's needs and circumstances. Also, the complexity of implementation would likely best be addressed through technology (rebalancing software). In the end, offering this type of tax savings service can be extremely beneficial to clients and can give you the edge over competitors – including robo-advisers.
