Talking Taxes: The Easiest “Fee” for Investors to Reduce

For many investors, taxes are a larger drag on performance than fees or trading costs and can prevent or delay their ability to meet long-term investment goals. By deferring taxes, your clients keep more money invested in the market. This can help improve their potential compounding growth rate and ultimately increase their total wealth accumulation over time.

Even a small reduction in current taxes can have large consequences for wealth accumulation. For example, an improvement of 0.5% per year in after-tax returns can result in a wealth difference of 50% after 30 years of distributions.¹

Help clients generate tax alpha
Tax drag is portfolio performance that is lost to taxes. It is the erosion of investment returns due to taxes paid such as tax on capital gains realized, dividends received or income generated. Think of it like a headwind: Even when investments are growing, paying taxes along the way reduces how fast clients’ wealth can compound.

Tax alpha, on the other hand, is the value recovered through active tax management. Just as traditional alpha measures the excess return a portfolio generates above a benchmark, tax alpha measures the excess return (or the loss of return avoided) resulting specifically from minimizing the impact of taxes. Here are five ways you can help generate tax alpha for clients:

1. Review the past sources of tax drag. Making smart investment recommendations requires an understanding of the tax consequences for different types of investment returns, proceeds, or profits. A client's total tax rate along with a review of the past sources of tax friction can help you identify areas of opportunity that might help minimize their portfolio’s tax exposure while maximizing potential after-tax returns in the future.
2. Consider asset location. Strategically place different types of investments into accounts that minimize their tax impact. Essentially match the tax characteristics of the investment with the tax characteristics of the account that holds them. For example, holding tax-inefficient assets in tax-deferred accounts, and tax-efficient assets in taxable accounts.
3. Incorporate a year-round tax-loss harvesting strategy. Help create a reserve of tax losses clients can use in future years to reduce the amount of gains that might be subject to taxes. Offer to work with clients’ tax professionals to identify how systematically harvesting tax losses can help improve future outcomes.
4. Diversify concentrated positions. For investors holding a single stock position that makes up a disproportionate share of their wealth, many are aware of the outsized risk and implications to portfolio volatility. However, they often choose inaction because triggering significant capital gains taxes feels like losing money. Explore the total amount of capital gains taxes clients would pay if they hypothetically sold some or all of their stock positions, and explore the potential avenues for deferring the capital gains associated with diversifying concentrated stock.
5. Maximize charitable impact. When clients contribute stocks (or other highly appreciated assets) directly to a qualified charity or planned giving vehicle, no federal capital gains taxes are due on the contribution. They may also be eligible to receive a charitable-income tax deduction. This is for the full fair market value of the gift, subject to a limit of 30% of adjusted gross income with a five-year carry forward on unused deductions.

Bottom line: With a thoughtful approach, taxes can be the easiest “fee” for investors to reduce.