For financial services firms, tax efficiency might mean helping their advisors reduce the tax burden for their clients. For individual investors without an advisor, tax efficiency is the same idea, but it can be approached in numerous different ways. Often, investors are left with incomplete information and misaligned strategies when they’re left to fend for themselves. When advisors finally look at the individual’s investment accounts, they often have to reorganize and reallocate assets to correct some of the tax efficiency mistakes.
As an advisor, you now have the potential to increase tax efficiency across an entire array of investment portfolios, whether clients are looking to maximize retirement income, find the proper allocation for their portfolio, or make a withdrawal or distribution. With efficient planning and management, advisors can add years of runway to a client’s retirement income through tax efficiency. If measures are not applied early on in an investor’s journey, clients may be leaving significant retirement income on the table.
Tax-Efficient Strategies Firms Should Consider For Investors
Investors fall on a spectrum. Some know exactly where they want their money (and why), and others don’t have a clue other than they need to invest for retirement. Some people fall in the middle of these two extremes, but advisors will be helping people all along the spectrum with their unique needs.
What does this mean for advisors? They need a variety of investment levers they can pull to increase retirement income for their clients at different points in their life. Every client is different. And each client can benefit from a different mix of tax-efficient investing strategies. Arming advisors with the right technology to execute this at scale is the key to gaining a competitive advantage in today’s market.
Contributions to Tax-Efficient Accounts
To help clients get the most out of the investments they are making for the future, advisors need to help them allocate funds to the most tax-efficient accounts. These accounts may include traditional IRAs, Roth IRAs, or 401(k) accounts that can help mitigate current and future tax liabilities.
Traditional IRA contributions are tax-deductible, depending on the income threshold. Traditional 401(k) contributions are made pre-tax and reduce the current taxable income but are subject to contribution limits per year. Roth 401(k)’s are made post-tax, so the growth is tax-free. Both traditional IRAs and 401(k) accounts offer tax advantages for the future, so it’s important to educate investors on the difference between each type of account and the tax implications of holding their money in each one.
Account Diversification Among the Unified Managed Household
Using smart-householding is a strategy that advisors use to look at the investment plan based on the aggregated view of all accounts within a household (portfolio of the client/couple). Your advisors will use this method to reduce investment costs, manage portfolio risk, and increase the tax efficiency of a household portfolio.
The mixing and matching of income sources throughout retirement come from a variety of accounts (and Social Security and pensions). That’s why it’s important to start coordinating accounts early on in an investor’s life. The advantages of tax efficiency are not immediate, but they are significant.
The ultimate goal is to help draw down funds across these accounts in a way that minimizes the tax burden and increases a client’s runway. Advisors are often required to look at all these accounts to find the best distribution strategy to keep taxes low and maximize retirement income. This is another place tax efficiency comes into play. There is an optimal way to take withdrawals across multiple accounts. Advisors just need the technology to do it.
Make Investments Tax-Efficient From The Start
Some investments that clients make are going to be beneficial to the overall tax picture from the start. Things like municipal bonds have tax-exempt earned income. Choosing to invest in these types of investments from the beginning may help a client plan better for the future without reducing their income when they retire.
In the same vein, there are other tax-efficient strategies investors can start with. For example, opening a Roth IRA is one of the most impactful moves a young tax-smart investor can make. If they can also contribute the max to this account each year, they will have an amazing head start when it comes to saving for retirement. All that compound growth is tax-free, so the earlier they start putting money into a tax-advantaged account, the better.
Use Asset Location as a Strategy
It is almost impossible to take advantage of a tax-efficient strategy if you aren’t putting your investments in the right accounts. Asset location works by matching each investment holding with the account that will provide optimal tax treatment. Advisors can use the strategy to help each client reduce their tax exposure and minimize tax drag across an entire array of household-level portfolios at once. This level of scale can only be accomplished with LifeYield technology.
When using an asset location strategy, the decisions about where to hold the various investments roll up to one overall household allocation. Rather than managing each account separately, there are many tax advantages to coordinating assets across accounts under one asset allocation. The allocation process involves dividing the investment portfolio among different investment accounts to achieve the greatest level of tax efficiency for each client.
Hold Investments Longer to Avoid Unnecessary Capital Gains
It should be noted that you probably should not hold on to a stock you are ready to sell just because you want to avoid the taxes on the gains, but there are exceptions to this. When you sell assets that you have held for less than a year, the gain is considered a short-term capital gain, which is taxed at ordinary income tax rates.
Assets held for longer than a year before sold fall into a long-term capital gain category. The tax rates for these capital gains are much lower than those of the short-term gains. The tax bracket for long-term gains for single filers is 0% ($40,000 or less), 15% ($441,450 or less), and 20% (greater than $441,450).
Use Tax-Loss Harvesting to Offset Gains
One of the best strategies that an advisor can do for clients is tax-loss harvesting to offset the gains made from selling securities. It helps to reduce the taxable income from that sale by selling other securities at a loss. Some specifics should be considered when using this strategy. It is important to avoid wash sales when selling to harvest losses. Advisors need to overcommunicate with clients when they’re executing this to make sure they’re not purchasing a similar stock for a certain period of time. If they do, the wash sale is null-in-void and they will still have to pay taxes on their initial gains. If losses exceed the gains, they can be carried over into future tax years.
Why Are Tax-Efficient Strategies Important?
This question might seem silly to some, but many potential investment clients out in the world have no idea that they could be minimizing their tax liabilities. Unfortunately, some people investing in retirement have no idea that they are jeopardizing their future income amounts just because of the tax burden they are facing.
Your firm can change this and create a strategy that is tax-efficient and maximizes the rate of return for clients. The best way you can help a client structure their investments to reduce their tax liability is by allocating funds to the right investment accounts.
But have you ever tried to execute this by hand or in spreadsheets? The results are all over the map. This tax minimization strategy can only be executed at scale using technology.
It is also important for your advisors and their clients to understand the changes that get made to retirement and investment legalities. For example, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 was passed by Congress and took effect for the 2020 fiscal year.
The SECURE Act of 2019 changed the way that traditional IRA contributions can be made. Now investors of any age can make contributions to these accounts and get a tax deduction. There was an age limit for IRA contributions before this was passed, and now there is none.
In previous years, those who waited to take distributions were required to take minimum distributions automatically at age 70 ½. The SECURE Act increased the minimum distribution age to 72, allowing account holders to wait longer before taking the required withdrawals.
If you’re going to execute a tax-efficient strategy for each client, you need to stay up to date on tax laws. With software to help make these calculations for you, you’ll never have to worry about misinterpreting a tax law again.
How a Firm’s Advisors Should Approach Their Clients About Tax Efficiency
Money is often a sensitive subject. Even talking to a client that you’ve known for years about their investments or strategy can be a difficult conversation if not approached correctly.
For all clients, taxes are a reality. Most investors want to avoid discussing taxes until it is time to file for Social Security and take distributions from their portfolio. Unfortunately, many clients don’t realize that it is too late for advisors to come up with a strategy that minimizes taxes at that point. A strategy like this requires investment clients to be proactive with their portfolio and trying to maximize tax efficiency BEFORE they approach retirement, not during or after.
Being tax-smart means looking at all of the elements that determine the client’s tax bill, not just earned income. Investment taxes are the single biggest drag on a portfolio’s returns. Setting this investment strategy up early on helps to achieve the best possible outcome for each client, tailored to their individual investment goals.
Why should advisors care about this?
Most clients don’t realize that they are an active part of the tax-efficient investing process. Utilizing strategies that reduce the tax burden and optimize the investment strategy will help produce the best possible investment outcome for clients AND advisors. After all, it’s what is left after taxes that matters most for the client. But more money in the portfolio means more revenue for the advisor. And that’s a win-win.
As stated above, clients aren’t the only ones who benefit from tax-efficient portfolio practices – your firm and advisors do, too. Advisors who can quantify the benefits being provided to clients are a huge step ahead of their competition. This can be their competitive advantage.
“I can increase your after-tax returns by $150,000 over ten years” is much better than “I’m going to do everything I can to help you avoid investment taxes”. This approach increases the trust between advisor and investor, creating long-lasting relationships.
Keeping Clients Happy with Tax Efficiency and Technology
Tax efficiency and technology essentially go hand-in-hand, especially for advisors. Traditionally the technology that advisors had access to only handled one account at a time, making it almost impossible to efficiently coordinate assets across a household.
The more retirement income an advisor can generate, the happier investment clients are going to be. If it becomes necessary for a client to make a withdrawal unexpectedly, they would hope that it will be done in the most tax-efficient way and as quickly as possible. There are some circumstances when they can’t wait days or weeks for their advisor to come up with the right strategy for taking a withdrawal. Technology can execute this in seconds.
That is how firms lose not only their top advisors but the clients as well – they don’t have the right strategy for handling expedited requests like these. Additionally, if a new advisor can tell them they’ll increase their retirement income by over $100,000 just by coordinating their assets, you can bet that client would jump ship.
So how can a firm accommodate advisor technology requests and keep clients happy?
LifeYield is a proprietary technology platform that automates everything tax for firms and their advisors, making it possible for advisors to handle client portfolios with 0 margin for error. The technology covers a variety of areas, including tax-efficient asset location, multi-account withdrawals, rebalancing, and tax harvesting. When used together, LifeYield APIs help firms take wealth management to the household level.
The Taxficient Score®
Think of this as an asset location score. The Taxficient Score® is LifeYield’s personalized approach of quantifying the tax efficiency of an investment client’s household. This score helps advisors take the current household and assign an efficiency score as it stands today. Think of this as a starting point to be able to see the potential increase in efficiency once optimized.
After running a portfolio through LifeYield, the Taxficient Score can then be presented to the client, showing the portfolio’s current level of tax efficiency. LifeYield also presents a series of next-best actions that advisors can take to improve the score. These recommendations come with a score improvement and dollar benefit so the client can understand the impact of each step. The result is an optimal outcome that leads to greater trust between advisor and client, improved client retention rates, asset consolidation, and increased referrals from satisfied clients.
The score ranges from 0 to 100, with a 53 being the average score across all portfolios using LifeYield technology. The number is indicative of the tax efficiency of the entire household and provides firms and advisors with a step-by-step blueprint to improve that score.
The LifeYield Technology Library
LifeYield changes the way that firms and advisors create a unified managed household. Technology that optimizes asset location, makes withdrawals tax-efficient, and maximizes retirement income may seem complicated, but the results are tangible. Clients have more retirement income, advisors build trust and AUM, and firms reap the revenue benefits of the entire value chain. It’s a win-win-win in the end.
LifeYield’s asset location technology reduces drag across the household portfolio and quantifies the benefit in dollars. Tax efficiency can be instantly improved thanks to the proprietary algorithm scanning all accounts and pinpointing the tax-smart location for every asset (in seconds).
The asset location score baked into the algorithm enables your firm to measure the household’s current efficiency and gives you a blueprint for improving it.
The best part? Asset location can be implemented without replacing your firm’s current technology. LifeYield can run alongside it, enhancing the experience without costly changes to the existing tech stack.
Traditional rebalancing looks at each account within a portfolio individually. LifeYield makes it possible to rebalance at the household level, which has not been possible until now. Especially after taking a withdrawal, many advisors and clients can benefit from automatically rebalancing a portfolio while minimizing drift from the household allocation.
After the withdrawal has been executed, there will often be some drift and a rebalance will be necessary. Rebalancing in this situation is complex and intricate. You want it to be tax-efficient, you want to make sure to avoid wash sales, and you want to look for opportunities to harvest losses – all at the same time.
That’s where LifeYield’s rebalancing technology is unique. It makes all of this possible at scale.
When your firm manages a household, one of the hardest tasks is to make sure that all opportunities for tax efficiency have been found. There are often many different variables, and traditional technologies can only handle one account at a time.
LifeYield’s proprietary engine makes it possible to look at all the assets within the household and identify which lots are the most tax-efficient for a withdrawal and how the portfolio should be rebalanced (if necessary). One API covers multiple aspects of the tax efficiency challenge.
With LifeYield guiding these withdrawals, you can maximize your client’s return, minimize the tax liability of the transaction, and ensure the portfolio stays in line with the target allocation.
The tax harvesting opportunities can go in either direction – losses and gains – depending on the client’s situation. In most circumstances, losses are harvested to help offset client gains for tax purposes. LifeYield makes it possible for your firm’s advisors to scan all accounts within the household (taxable and non-taxable), looking for optimal harvesting opportunities. While this is happening, LifeYield also helps to avoid wash sales.
Using LifeYield makes it possible for tax harvesting to be implemented at the household level. Now advisors have a solution that automates the process and makes it easier to harvest gains and losses almost instantly. Tax harvesting is baked into all of the LifeYield Tax Efficiency API logic, making it the most complete solution on the market.
Working Across the Unified Managed Household
The unified managed household strategy provides an aggregated view of the assets within a household. The goal is to look at all the assets at once, not individually. The industry is now making it apparent that advisors need to be focusing on and delivering a holistic, customized approach to help clients reach their goals. Comprehensive and coordinated platforms include the following:
- Customer Relationship Management (CRM) Systems – allowing advisors to segment the books, position the most relevant offerings to the client and personalize and target offerings for specific clients.
- Financial Planning Applications – providing comprehensive financial and tax advice across multiple areas, including investments, insurance, and lending solutions that consider the client’s assets, liabilities, and potential earnings.
- Holistic Risk Management – supporting clients and connecting their overall investment goals with the way they view their world, leading to better investor outcomes.
- Tax Optimization – optimization practices across multiple accounts and products to ensure that tax-smart asset location has taken place.
- Account Data Aggregation – unifying all the holdings within a household that are held by various custodians.
- Optimal Income Sourcing – income sourcing and sequencing from multiple accounts, products, and other income sources such as Social Security, pensions, Roth IRA, 401(k), and other tax-exempt accounts.
Why LifeYield For Tax-Efficiency?
LifeYield has been battle-tested by some of the biggest names in the financial industry. These include Allianz, Merrill, Morgan Stanley, Jackson, Personal Capital, and more. The technology provides firms and advisors the ability to view and manage multi-account portfolios and recommend the strategies that will best improve the after-tax return for the client.
The purpose of LifeYield technology is to help firms create and execute on the promise of a Unified Managed Household for investors. With Social Security barely functioning as a baseline for most retirees, investors need to build wealth throughout their lifetime. The best way to do this is to maximize the efficiency of what they already have. LifeYield technology helps to enhance the existing software platforms at the largest firms in the world, add tax efficiency as their competitive advantage, and quantify the benefits of this strategy for all their clients.
A Unified Managed Household is no longer a pipe dream. With LifeYield, it’s a reality.