"You must pay your taxes. But, there's no
law that says you gotta leave a tip."
–Morgan Stanley advertisement
As the relief of tax season fades into the deep corners of our memory, many taxpayers may be sitting back thinking they’re done; they’ve successfully filed their taxes so they can relax and (hopefully) wait for that refund to hit their account. Before you start putting your legs up and planning that summer vacation, remember that if you are not careful you may inadvertently be giving away your hard earned money to the IRS by delaying in planning and preparing for next year’s return.
At Kabarec Financial Advisors, Ltd. (KFA), we are routinely tax planning for our clients to generate tax alpha - the value-add that an advisor provides by implementing “proactive tax strategies that generate tax savings, particularly in a portfolio (where the larger the portfolio, the larger the potential tax benefits).1 As reputable sources like Vanguard, Morningstar and Envestnet point out, strategic tax planning is worth 0.70% to 3%in annual tax alpha, and that estimate does not include the potential benefits of income tax planning, such as tax bracket management - the process of strategically managing your controllable income in conjunction with marginal tax rates to improve overall tax efficiency. We consider the following high level strategies for all of our clients:
Asset Location– Vanguard research shows that asset location can provide clients with up to 0.75% of additional annual return2. Asset location is a tax minimization strategy that locates investments based on two primary factors: an investments tax-efficiency and its expected returns. For example, placing traditionally high growth and high turnover assets, such as emerging markets and sector rotation fund in the tax-free Roth, or sheltering investments that generate high ordinary income, such as taxable bonds in a tax-deferred IRA. A good asset location reference is Chart 1, “the full asset location smile and the asset location priority list” from The Kitces Report, “Advanced Concepts & Strategies in Asset Location”. In addition, asset location is most effective when the strategy is implemented at the “household level” versus at the account level. Therefore, when considering an asset location strategy for your investments look for firms (like KFA) that can diversify your investments at the “household” level.
Source: Michael Kitces, The Kitces Report
Municipal bonds– One of the principal assumptions of an effective asset location strategy is to use taxable bonds in tax-deferred accounts. However, in certain situations where the tax-deferred accounts are not large enough to properly diversify a client’s investments between stocks and bonds, tax-exempt municipal bonds are a good option. In addition, when considering municipal bonds in a taxable account, investors should review their tax bracket to determine if tax-exempt municipal bond yields are comparable to U.S. Treasuries. For example, 10-year AAA municipal are currently at 1.32 relative 10-year U.S. Treasury bonds, and the tax equivalent yield for a 15%, 28% and 35% tax brackets are 2.03, 1.83 and 1.18 relative to 10-year U.S. Treasury bonds. Table 1 shows the comparison of the U.S Treasury Yield Curve to the AAA Municipal Yield Curve.
Tax loss harvesting– Tax loss harvesting is the strategy of selling securities at a loss to offset a capital gains tax liability, without permanently changing the underlying investment/portfolio. Evestnet’s “Capital Sigma: The Return on Advice” shows that a properly tax managed portfolio may be worth 0.60% annually over a buy-and-hold portfolio.3 Investors should be aware that Congress has passed a 30 day “wash sale” to limit potential abuses. The wash sale rule requires that a tax loss can only be claimed by investor’s if the replacement investment is not “sustainably identical”. In addition, investors should note that tax loss harvesting may trigger a future gain, and thus the value of tax loss harvesting is really in the tax deferral of the loss from time originally claimed until the recovered loss is triggered. For example, an investor buys a stock for $10,000 and its value declines to $6,000. The investor can harvest a $4,000 tax loss, but in doing so, the investment will now have a cost basis of $6,000. When the client sells the stock for $10,000 (the original purchase price), the investor’s gain will be $6,000 (so the net gain is $0). 1
Income Tax Planning– The 3rd and 4th quarter of every year, KFA helps clients’ tax plan going into the end of the year. This includes running illustrations to help minimize a client’s tax burden. We use various strategies, including harvesting gains, tax bracket maximization strategies such as Roth conversions or retirement withdrawal ordering optimization, charitable giving and gifting strategies, and the classic tax deferral strategies (e.g. IRA’s). As Michael Kitces points out, “the tax bracket arbitrage opportunity… is often the biggest tax planning opportunity available”, but it is difficult to quantify.1
Kitces, “Evaluating Financial Planning Strategies and Quantifying Their Economic Impact” The Kitces Report, Volume 3, 2015.
Kinniry Jr, Jaconetti, DiJoseph, Zilbering, Bennyhoff, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, September 2016.
Envest PMC’s Quantitative Research Group, “Capital Sigma: The Return of Advice”, 2016.