Five Tax-Smart Steps to Help Clients Build Wealth

Make the most of tax-advantaged accounts
Tax-advantaged accounts such as 401(k)s and Individual Retirement Accounts (IRAs) offer significant tax benefits that may help accelerate the potential growth of your client’s investments. For instance:

Traditional 401(k)s and IRAs generally allow your client to invest pre-tax dollars, which can potentially grow tax-deferred until withdrawals begin, typically in retirement. Qualified withdrawals are taxed as ordinary income.

Roth accounts are funded with after-tax dollars and offer potential tax-free investment growth and withdrawals.

Choosing between these accounts often depends on your client’s current tax bracket and expected financial situation during retirement. If your client anticipates being in a lower tax bracket after retiring, traditional accounts may be more beneficial. Conversely, if your client expects higher tax rates in the future, either because of adverse changes to tax rules or due to being pushed into higher tax brackets due to the required minimum distributions (RMDs) from qualified accounts, Roth accounts could be more advantageous.

Additionally, some employers offer options to convert after-tax contributions to a Roth 401(k), offering the potential to contribute additional funds, up to a higher limit than that allowed by the IRS on elective salary deferrals.

Invest in stocks tax-efficiently
Investors who are up against the contribution limits on tax-advantaged accounts or face eligibility restrictions or other constraints may consider how managing stock investments for tax efficiency can lead to potential tax savings.

Direct indexing, for example, allows investors to own individual stocks in a way that seeks to replicate the performance of a market index. This strategy enables personalized tax-loss harvesting opportunities, which can potentially reduce an investor’s tax liability by offsetting taxable gains with losses.

Consider smart bond investment techniques
As your client diversifies their portfolio, incorporating bonds can be crucial, especially as a potential buffer against market volatility in later life stages. Some bonds offer more tax-advantaged opportunities than others. For example:

Investing in municipal bonds can be a smart choice. These bonds are generally exempt from federal income tax and, in some cases, from state and local taxes, which may make them attractive for investors in higher tax brackets. Muni bonds can provide investors with fixed income payments and capital preservation, but it’s their tax advantages that investors are often most curious about.

Explore tax-aware alternative investments with a financial advisor
For qualified investors with a financial advisor, alternative assets can help diversify your client’s portfolio and enhance returns. However, they may come with a heavy tax burden.

One emerging category of alternative investments, however, seeks to address this. Tax-aware “long-short” strategies, deploy investment techniques commonly used by hedge funds alongside a tax-loss harvesting strategy that may help reduce tax liabilities.

Additionally, investing through vehicles like private placement life insurance (PPLI) or private placement variable annuities (PPVA) may offer tax-deferred growth potential, further enhancing the tax efficiency of your client’s portfolio’s alternatives exposure. PPLI and PPVA are structured as variable universal life insurance policies and variable annuities, respectively, but are sold privately. They enable high-net-worth (HNW) investors to access alternative investments such as hedge funds and private equity, potentially deferring taxes on investment gains.

Investors should discuss the consequences of these investments with their financial advisor and/or their tax advisor before investing.

Employ comprehensive tax management across a portfolio
Seeking tax efficiency isn’t just about selecting the right investments, it is also about how and where your client holds them.

An asset location strategy – not to be confused with asset allocation – can help to maximize the tax advantages of specific accounts, using the tax code to an investor’s benefit. Asset location involves deciding where to place each investment to help maximize after-tax return potential. For example, investments with high growth potential but low tax efficiency might go in tax-advantaged accounts, while investments with lower growth potential but higher tax efficiency could be held in taxable accounts. If an investor is retired or in any case taking distributions, making the right choices about which accounts and investments should be sold and in what sequence can also have highly beneficial impacts on tax costs.

How to find the right solution
Sophisticated investors should consult with a financial advisor or tax advisor who can provide personalized investment advice based on an investor’s specific financial situation and goals. An investor can ask about tax-efficient investing guidance on alternative investments, which can be accompanied by a heavy tax burden, and how to use equity exchange funds if an investor has highly appreciated individual stocks.

Bottom Line: Tax-efficient investing is a dynamic and complex aspect of financial planning that requires careful consideration and strategic decision-making. By understanding and utilizing the various accounts, investment types and strategies available, an investor may be able to enhance the potential after-tax returns of their portfolio.