Given the past several years of strong equity markets, the implications of tax costs when rebalancing a portfolio can be significant for taxable portfolios. We find that many clients view these taxes as an increased “cost” to portfolio management they are not comfortable absorbing. As advisors, this presents a challenge in trying to manage and rebalance for better after-tax outcomes.
We also find that clients who have highly appreciated and concentrated securities in taxable accounts create significant portfolio management complexities. A potential solution is engaging a manager to provide a tax overlay for more disciplined after-tax portfolio management.
Tax and investment management complexities continue to exist, even with the passage of the Tax Cuts and Jobs Act (TCJA). For those at the highest income brackets the TCJA did not “move the needle” on reducing capital gain rates. Top earners’ maximum marginal rates for short-term capital gains are at 37%. The highest tax rates for long term capital gains remain at 23.8% when factoring in the 3.8% net investment income tax (aka “Medicare surtax”).
The impact of elevated tax rates on high net worth individuals can be profound when gains are realized as part of a disciplined rebalancing process, but clients often loathe the ensuing taxes. They feel “trapped” in a portfolio that contradicts their target asset allocation. Further complicating this conundrum, high net worth investors often hold highly appreciated and concentrated securities that need to be reduced to lower their “single stock exposure” and free up cash for lifestyle demands.
While this seems technically straight forward, the act of selling highly appreciated and concentrated securities to lower a portfolio’s risk profile is often emotionally unacceptable. We find that clients resist this disciplined approach to manage the risk of their portfolio.
Benefits of a tax overlay manager: A compelling solution to these barriers is a tax overlay manager. This approach emphasizes the synergies between tax loss harvesting and tactical portfolio rebalancing. At a high level, the manager builds a portfolio to match a relevant benchmark and continuously harvests losses to build loss reserves for future use.
Tax-loss harvesting involves constantly monitoring loss recognition opportunities (during down and up markets) across positions and trade lots. Harvesting losses throughout the year provides flexibility to potentially minimize short-term capital gains and future long-term gains. The manager will harvest losses by replacing existing positions with comparable companies during the 30-day wash sale period.
For example, selling Pfizer below its cost basis creates a realized tax loss and is replaced by shares in Johnson & Johnson, which allows the portfolio to maintain the health-care exposure with similar risk factors. The realized losses incurred from selling Pfizer should reduce the effects of selling highly appreciated and concentrated holdings that are contributed to the manager’s portfolio. This approach lowers the eventual tax cost of rebalancing taxable accounts.
How to achieve this: Working with a firm that specializes in delivering more efficient after-tax outcomes is a reliable solution. Typically, a team will analyze a client’s existing positions (using tax lot and cost-basis data) and map out investment-transition strategies to reduce unnecessary exposures and minimize the tax impact.
Ultimately, the calculated transactions should streamline the asset allocation to better meet the client’s needs. The transition strategies can also be tailored to encompass varying scenarios in terms of tax cost versus tracking error of a target benchmark (e.g., a global equity strategy with a large cap tilt that focuses on dividends).
In closing, rebalancing is a prudent approach for optimal long-term portfolio goals, but the emotions and costs of taxes are real. Putting the right solutions in place creates a plan to optimize these objectives for taxable portfolios.