Dear Advisors: Here’s How to Treat Taxable Portfolio Gains

By Brian O'Connell

When advisors don’t apply tax management tools to their clients’ taxable portfolios, they lose an enormous opportunity to add value.

“For investors, after-tax gains are the ultimate measure of investment performance,” said Greg Vigrass, president of Folio Institutional in McLean, Va. “Yet, some advisors believe tax optimization requires too many resources or is too complicated to integrate into their day-to-day account management processes.”

Advisors who downplay portfolio tax management could making a big mistake -- for themselves and for their clients.

In the 2016 report, “Tax-Efficient Investment Management 2006-2014, A Case Study,” Ballentine Partners’ analysts were able to add approximately $18.8 million of value to a $300 million portfolio by: (1) strategically locating assets to save gift tax, estate tax, and generation-skipping tax and (2) active tax management of the portfolio.

It’s not easy to undertake regular and effective active tax management of investment portfolios, Ballentine concluded.

“Active tax management requires a high level of attention and skill on the part of the portfolio manager,” said Michael Chimento, a financial planner and managing director with the firm. “It also requires collecting and analyzing information about the client’s tax situation throughout the year. In order to do this, we had to create our own systems and, as far as we know, no other wealth manager has attempted that.”

Big Losses

A substantial portion of investors’ realized gains can end up lost to taxes, Vigrass said, which could run afoul of the new Department of Labor fiduciary rule.

When an advisor does look to create and active tax management campaign, Vigrass advised taking the following key steps:

• Use tax-modeling tools to educate clients. Some clients need to “see it before they believe it” and may not always appreciate the tax implications of their investment decisions. “Using a tax modeling tool can help advisors show clients the outcomes of any number of taxable investment scenarios and choose the one that is best for them,” Vigrass said.

• Make taxes a part of the annual IPS review. “Discuss with clients the effects of their investments on their taxes, and update their investment policy statement accordingly,” Vigrass advised.

• Conduct a mid-year tax review. Use this opportunity to talk with clients about their tax obligations and upcoming cash needs.

“Even if clients have otherwise manageable or no upcoming cash needs, an advisor can help them develop a plan to pay for future taxes,” Vigrass said.

• Strategize with the client’s accountant. Collaborating with a client’s accountant can go a long way in adding value to the relationship.

“An advisor can provide a view into the investment strategy and how it affects plans to maximize investment returns while minimizing the client’s overall tax bill,” Vigrass said. “Building connections with gatekeepers, such as accountants, can also help drive referrals.”

So why aren’t more investment advisors tackling the client portfolio tax management issue?

“Many advisors are commissioned-based advisors and as such, pursue a failed strategy of ‘active portfolio management,’ wherein they basically surrender their tax management to the whims of the mutual fund's portfolio management team,” said Bob Barry, president of Barry Capital Management in Washington, N.J.

Keep it Simple

Expense ratios, undisclosed trading costs and taxes also extract a toll on investors that's hard to overcome, Barry added.

“The reason that so few mutual fund managers beat the market is more or less because they've become the very market that they're trying to beat,” he said.

A simpler strategy would be to pursue a passive strategy using either index or ETF alternatives.

“For example, the iShares S&P 500 ETF has never paid a taxable distribution in its nearly 15-year history,” Barry explained.

A potentially larger issue links tax management to "passive vs. active” portfolio management.

“It's been a long-held debate, and there are clearly subtle asset classes that call out for active management,” Barry said. “Yet, the client's core portfolio should be comprised of passive alternatives.”

An even larger problem is that advisors just don’t make taxes a priority with their clientele, leaving it to accountants to pick up the slack.

"Ninety percent of investment advisors hate discussing taxes,” said Anthony E. Parent, founder of Parent & Parent near New York City. “They avoid it at any costs. And 90 percent of tax professionals are too myopic to be concerned with ROI.”

It’s rare to find an investment advisor who is obsessed with net return on investment, and it is rare to find a tax professional who can look outside their compliance bubble, Parent added.

“Those investors who have found one or the other, or both, have a strategic advantage,” he said.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at [email protected].