Nobody really likes paying taxes. So, what would your clients say if you could make it so they don’t have to pay any taxes on their investment portfolio’s capital gains?
Just because something is true doesn’t mean it’s right. However, many asset managers and advisors still use the promise of low-tax or zero-tax wealth management to appeal to clients without telling them one important caveat – that it will be very challenging to access those investments during their lifetime without paying taxes.
Why do so many in the industry do it? Because talking about taxes and showing clients their tax bills is hard, and many advisors would rather do just about anything than show a tax bill from investments. Using tax deferments makes it easier to show a positive result (little or no taxes) at the end of any given year, which makes clients happy. But of course, the tax bill is just getting kicked down the road, and unless the client dies and passes the assets to heirs, they will have to pay the taxes someday. In a worst-case scenario, they may suffer a “tax bomb” and may not appreciate the size of the tax bill and actual after-tax wealth just when they need it most.
If you think explaining the tax bite is hard now, just imagine the conversation in 20 years if you keep deferring without being transparent about the tax liability.
Instead, advisors should approach taxes and tax management holistically, which I like to think of as “Tax-managed investing for a life well-lived.”
What is Tax-Managed Investing for a Life Well-Lived?
This approach to taxes that maximizes the value of clients’ portfolios with the goal of having enough assets available to live the life they want, even after paying taxes.
Basically, it’s what a good advisor should already do: Learn about your client’s dreams, desires and needs, and apply a tax management approach that optimizes their assets for those goals.
- Start by asking what is important to them in life. What do they value? What’s on their bucket list? Knowing that a client wants to travel in retirement, wants to buy a second home, and wants to give to charities helps you calculate how much money they will need access to over the years.
- Be realistic about future expenses. Most people will have expenses in retirement they didn’t have before, healthcare and long-term care chief among them. You can’t predict the future, but it’s smart, responsible advising to ensure clients can access funds in an emergency that an underappreciated tax bomb won't gut.
- Engage clients in conversations about legacy. Talk with clients about the money they don’t need for their own life (if any). If they want to give it to charity while still alive, that’s one tax strategy. If they want to give it to their kids as an inheritance, that’s another (and a case where ongoing deferments may make sense, with caveats.)
- Be transparent about tax law. Deferred taxes need to be paid in full when the asset is sold by its owner. There’s generally no getting around it. When inherited, the capital gains clock resets, so the next generation will pay taxes on gains realized after they receive the asset.
- Don’t let the tax-tail wag the dog. You owe it to your client not to have them pay more taxes than they need to, but a single-minded strategy of tax avoidance is oftentimes not in a client’s best interest. Sure, you could invest everything in municipal bonds and limit the amount paid in taxes on income – but what you have at the end may well be less than if you invested in a diversified, tax-smart approach.
Deferments, Timing and Tax Strategy Still Matter
This isn’t to say that there is no value in deferments. Being smart about when you pay taxes to minimize their impact or maximize cash flow in years when a client needs it is absolutely a value advisors can and should deliver. A tax not paid can be powerful. However, one should not hold a less-than-ideal portfolio to avoid a possible tax.
Advisors should also be mindful of the tax environment. Different administrations and congressional leaders have different tax plans, so paying taxes when capital gains tax is lower makes sense. Understanding that income generally goes down in retirement, and so may also lower the capital gains tax rate, can also provide advisors with a way to minimize the tax bite.
In all of this, be realistic about inheritance. We in the business like to talk about the “great wealth transfer” coming from Baby Boomers. But not all investment portfolios are going to be passed on to heirs. Most people will need or want to spend parts or all most of their assets during their lifetime – so making sure taxes are addressed responsibly along the way is crucial.
Use Tax Strategy to Support a Life Well Lived
At the end of the day, it’s about helping clients live well – whatever that means to them. As an advisor, you can help them not only manage their assets responsibly but also help them see their dreams more clearly and how they can achieve them.
If clients want to fly first class, or splurge on themselves, they should be able to do so without regret. It’s their money and their life. Making as much of their money as possible available to them is your job – and one you can do better by taking a more holistic view of tax management.
Frank Pape is Director of Strategies for Frontier Asset Management.
