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Tax Efficient Investing: How Tax Pressures May Impact the Investment Management Landscape

Posted by Sean Cunniff, Investment Management research leader, Deloitte Services LP, on July 23, 2014

In late April of this year, I was chatting with two of my neighbors after a town hall meeting. One, a certified public accountant, remarked to the other, a trust officer at a regional bank, that it had been a very unpleasant tax season. The trust officer agreed, stating that his firm had received more complaints about taxes than any other time in recent memory.

I believe the clear reason is that many people, particularly those with higher incomes, are just now feeling the pain of recent tax increases. These increases include the new Medicare surcharge, the increase in the top rate to 39.6 percent, the increase in the rate for long-term gains and qualified dividends to 20 percent, as well as the phase-out of several exemptions. Taken together these changes resulted in significantly higher taxes for many individuals.

The town hall conversation about the uptick in complaints about taxes made me wonder if investors will become more tax sensitive in the future and if the interest in "tax efficient" investing will grow.

Here are a few thoughts:

Tax impact is real but not always apparent
Taxes can have a significant impact on financial outcomes and on the net after-tax cash available following a transaction, such as a sale of securities. However, investors are not always aware of the extent of the impact until well after the transaction. This lack of awareness could result in more taxes paid by the account holder than if tax planning had been in place.

Exactness with taxes is possible, but difficult to achieve
Tax exposure can be managed — to an extent. However, doing so is very complex, requires significant planning, and involves many assumptions, such as the future of tax rates. Using history as a guide, we can be confident that tax rates will not be the same as they are today. This and other necessary assumptions make long-term tax planning very challenging.

Tax advice is personal and very hard to scale
Because the tax code is complex and individual situations are unique, it is very hard to build tools and processes that are effective for large numbers of people. One industry executive told me that each line of an investor's tax return should be reviewed in order to provide truly effective tax planning. In addition, advisors need to understand the investor's wealth- transfer goals and objectives. These are very challenging services to scale.

Tax data and information can be helpful
While scaling tax advice is very difficult, it is possible to provide automated tax information. For example, investment managers and brokerage firms are now required to report cost basis information to the IRS. At some financial service institutions this same data is being reported to customers. For example, before placing a trade, a customer is made aware of its potential tax impact and/or warned that a wash sale might be taking place. This information can help financial advisors work more proactively with tax advisors to determine better outcomes for the client.

Tax diversification offers flexibility
The three primary types of investment accounts are taxable, tax–deferred and tax-free. In an environment where future tax rates are unpredictable, it may make sense for many taxpayers to hold at least some assets in each type of account. This offers the most tax flexibility, no matter what happens in the future, when drawing down assets for retirement.

Asset location has an impact
Another important concept that is linked to tax diversification is "asset location," which refers to the type of securities that are held in an account type. For example, it may make sense to hold income-producing assets such as taxable bonds in a tax-advantaged account in order to defer taxes wherever possible. Academic research1 has shown such strategies can have a material impact on financial outcomes.

Taxes–loss harvesting: tread carefully
Tax-loss harvesting is a well-known tax management technique, used by investors and advisors. Used correctly, it can be very effective; however, it is no panacea. Because every harvested loss reduces an investment's cost basis, it is a deferral of taxes into the future. This can work out very well, but may also cause an investor to pay higher taxes in certain situations.

Financial services institutions tend to tread carefully in the area of taxes, since many do not offer tax advice. However, certain firms are not ignoring the tax issue. Some companies are offering enhanced tax data as mentioned above, some offer tax overlay portfolio management, and others work closely with their client's tax advisors. My sense is that along with changing tax rates and complexity, the interest in tax-efficient investing will grow for the simple reason that tax liability is one of the few areas where investors may see a direct impact.

What do you think?

1James Poterba, John Shoven, and Clemens Sialm, "Asset location for retirement savers," The National Bureau of Economic Research, November 2000.

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