Tax efficiency in taxable, non-qualified accounts
Key point
One way advisors can show value is decreasing an investor’s taxes and increasing their after-tax legacy by systematically implementing dynamic capital gains management strategies. Income Discovery’s intelligent engine AIDA gives guidance on the optimal tax strategy for each household and provides straightforward instructions for ongoing management of the chosen strategy.
An investor working without professional guidance may simply liquidate assets as needed without much thought. Advisors approach liquidating taxable assets in a variety of ways from general heuristics, to spreadsheets and calculators, to financial planning tools and managed account systems – all with the typical focus of tax location when rebalancing and reducing taxable income when selling assets.
However, beyond making a withdrawal, there are further questions on what to do with generated taxable interest and dividends, when to rebalance, when to realize losses, and when to proactively realize gains to increase basis. AIDA implements comprehensive capital gains management strategies as part of a holistic retirement income plan through a Unified Managed Income program.
Systematic Capital Gains Management
Systematic capital gains management (CGM) is the dynamic implementation of a set of rules for a household’s taxable, non-qualified investment accounts. AIDA assists an advisor in finding the optimal CGM strategy for each unique household, then monitors and implements the steps throughout the retirement income plan.
CGM determines for each taxable account, given its asset allocation, whether to use for income or reinvest the generated taxable interest and distributed capital gains. It also determines how to tap each account when sourcing any income needs. Finally, it determines throughout the year the optimal way to rebalance and look for opportunities to harvest losses and realize tax-free gains.
While evaluating the topics below, references will be made to the Perch household with $1.9MM in assets and a $400K pension from the Optimized Personal Retirement Income Strategy post.
What Advisors do today
As stated, most advisors have systems to help investors liquidate their portfolios efficiently. Some advisors also offer tax-loss harvesting (TLH) for their clients. TLH has also become a key premium feature for many robo-advisors. Harvesting losses and minimizing realized gains throughout the tax year has many potential benefits from reducing capital gains taxes, reducing total taxable income, reducing taxable Social Security benefits, increasing available Roth conversions, and increasing available tax-free capital gains. These are key parts of AIDA’s full capital gains management strategy.
Full Capital Gains Management with AIDA
In addition to tax-loss harvesting, to fully maximize the short and long-term benefits of CGM, a systematic approach of applying tax-efficient disbursals and rebalancing across a household’s taxable accounts, plus dynamic targeting of tax-free gains needs to be evaluated and implemented as part of a holistic retirement income strategy.
For this example, the Perch family has agreed to a plan that safely provides $143K/year in base spending following sequential taxable disbursals and no advanced CGM (card 1). Their advisor is able to show some reduction in risk and increased average after-tax legacy by adding standard tax-loss harvesting to the strategy (card 2).
By adding AIDA’s comprehensive CGM (card 3), the advisor is able to maximize the benefits to the Perch family. This includes optimally using taxable interest and distributed gains, tax-efficient disbursals from taxable accounts, tax-loss harvesting, and dynamically targeting tax-free gains. Just by adding CGM, the Perch family can increase the performance of their plan or, alternatively, can increase their safe after-tax inflation-adjusted income by $2K/year.
On the base plan’s median simulation, adding CGM has a number of benefits highlighting the advisor’s value:
- reduces cumulative taxes by 10%
- reduces taxable Social Security benefits by $100K
- targets an additional $290K in tax-free gains
- total tax-targeted qualified gains were increased by nearly 20%
All metrics of the plan are improved with average after-tax legacy increased over 70%, shortfall dollars in the near-worst case scenario reduced 15%, and the risk of experiencing a shortfall reduced from 10% to 7%.
Conclusion
Advisors are looking for ways to stand out and show their value to clients, especially those entering retirement. Capital gains management is a way for advisors to show their value and expertise. All clients, from low net worth to ultra high net worth, are looking for ways to reduce their tax burden and decrease the government’s share of their assets. By tactically realizing gains and losses throughout a retirement income plan, an advisor can help an investor achieve those goals.
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