Tax Day has come and gone.
As advisers to high-net-worth individuals and families, tax planning is a year-round priority. HNW clients have wide-ranging objectives that include everything from transferring large amounts of money to younger generations, to minimizing their portfolio's correlation to the overall market.
This is what we tell them to assuage their anxiety: taxes are not something to be afraid of;
they're something to be aware of. If a client is feeling stressed about reckoning with the tax exposure in their portfolio, here are some basic considerations they can make throughout the year to guard against any lingering fears of unseen liabilities or unclaimed benefits before Tax Day rolls around again.
Remember the bigger picture
Most investors don't think about their taxes too deeply outside of tax season and this can leave clients vulnerable to making irrational portfolio investment decisions.
It's important to remember that taxes are but one aspect of the portfolio. Clients should not sacrifice their asset allocation to protect from potentially paying more in capital-gains taxes. More importantly, the reason they are investing in the first place is to generate after-tax returns. As one of my partners likes to say, "It's not what you make, it's what you keep."
Reducing tax exposure not that hard
On the equity side of the market, one common way investors minimize their tax exposure is by owning
passive ETFs instead of actively managed mutual funds. Mutual funds are naturally the less tax-efficient vehicle of the two due to their creation of more taxable events.
But if the desire is to beat the fund benchmarks, and they're able and willing to take on added risk, consider replicating a mutual fund with individual stocks in your portfolio.
Provided you have the capital to duplicate the exposure of whatever you're targeting, you can even replicate the indices by owning all the individual stocks.
This is a technique known as separately managed accounts, or SMAs. The active management of individual stocks, while potentially resulting in higher fees compared to owning passive ETFs, helps us utilize ongoing tax loss harvesting to take advantage of volatility and the ever-changing equity market valuations.
It also means that your cost basis in a stock is the price you paid for it, not what the mutual fund paid for it (think of a mutual fund that has owned Apple since 1990 and the embedded gains sitting in that fund you buy into).
[Recommended video:
Ed Slott: Advisers should be doing Roth conversion projections for this year]
On the fixed-income side, some investors (especially those in low tax brackets) may sacrifice the returns of higher-yielding bonds in favor of owning tax-free municipal bonds. Remember, it's OK to pay a tax if your net after-tax return is going to be higher.
I've written before about the benefits of
alternative investing. While many alternatives can be highly taxed, the benefits (such as diversification) can potentially outweigh those risks. In our case, we feel strongly about the value in private equity, real estate, and private debt despite their tax exposure.
Planning for taxes is a wise decision every investor should undertake. Just remember that paying taxes isn't always a bad thing; so, focus on after-tax return and take advantage of tax efficient structures when available.
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Consider the alternative)
