Asset Accumulation and Portfolio Positioning

Financial Planning

Clients often have a mixture of taxable, non-taxable, and tax-advantaged accounts, savvy wealth managers need to consider the interplay of these accounts, especially as clients approach retirement and begin to spend down their portfolios. The following are tax-savvy approaches to the financial planning phase:

• Financial planning: Using after-tax growth inputs assumptions.
• Asset allocation: Using after-tax return and volatility assumptions.
• Asset location: Placing tax-efficient investments into non-tax-advantaged accounts.
• Retirement income planning: Optimizing withdrawal strategies using taxable and tax-advantaged accounts before non-taxable accounts.
• Charitable giving: The gifting of highly appreciated stock in lieu of cash.

Asset Location

Choosing account types depends on both their availability and also the clients desired after-tax asset allocation. Tax location is a prime consideration. Tax location refers to the placement of various assets in either:

• Taxable.
• Tax-deferred.
• Tax-exempt accounts.

Depending on their tax efficiency: Tax efficiency depends on the local jurisdiction and the type of investment returns generated by the investment. At this point in the reading, it is sufficient for candidates to know that tax location encourages the placement of:

• Tax-efficient investments in taxable accounts.
• Non-tax-efficient investments in non-taxable accounts.

Capital Accumulation in Taxable, Tax-Deferred, and Tax-Exempt Accounts

Taxable accounts are subject to various taxes on the following income:

Tax-exempt accounts are not subject to taxes on the returns earned.

So, the after-tax future value of the portfolio does not depend on tax rates and is calculated as follows:

$$ FV=(1+R)^n $$

Where:

\(R\) = Annual return

\(n\) = Number of years

The value of a taxable account grows based on after-tax returns (R’). This approach assumes that taxes on earned returns are settled and tax credits are received in each period, treating the tax payment as a cash flow.

$$
FV=(1+R’)^n $$

In a tax-deferred account, the value accumulates with pre-tax returns, and taxes are only applied when assets are taken out from the account, usually at income tax rates. Assuming all assets are withdrawn as a lump sum at the end of the investment period with a tax rate of ‘t’, the taxation is calculated accordingly as follows:

$$
FV=(1+R)^n (1-t) $$

Asset Allocation

Private wealth clients typically have assets spread across taxable, tax-deferred, and tax-exempt portfolios.

Asset allocation for these clients involves not only determining the overall mix of asset classes but also deciding which asset classes are best suited for each type of account. This process is known as asset location.

A common guideline is to place tax-efficient assets in taxable accounts and tax-inefficient assets in tax-exempt or tax-deferred accounts. For example, taxable bonds may be better suited for a tax-exempt account, while equities, benefiting from preferential tax rates on capital gains, could go in taxable accounts.

Tax-efficient Decumulation Strategies

As clients accumulate assets and begin to retire, they will need to use funds from their portfolios to satisfy living expenses. The curriculum goes into some detail here, with examples of the right and wrong ways to use decumulation strategies. The main point is that since tax-exempt and taxable accounts compound at a higher rate of return, they should be left to the end of the decumulation phase where possible. Taxable accounts should be accessed and drawn down first. Of course, other considerations such as restrictions and the size of the accounts need to be taken into consideration.

Charitable Giving

Donating highly appreciated stock is preferred, where allowed, to gifting in the form of cash. Many jurisdictions allow for charitable donations of stock. This form of giving may accomplish two benefits simultaneously (where permitted):

• Investors receive a tax deduction (lowering taxable income in that year).
• Investors remove a future tax liability from their portfolio.

Tax Management and Basic Tax Strategies

There are two main categories of fundamental portfolio tax management strategies:

1. Arranging a client's investments in a lawful fashion to minimize their tax liability. Some examples include:

   • Maintaining investments within a tax-advantaged account as opposed to a taxable account;
   • Opting for tax-free bonds over taxable bonds when making investments.
   • Maintaining assets for a duration that meets the criteria for receiving long-term capital gains treatment.
   • Maintaining a position in dividend-paying stocks for an extended period to benefit from the more advantageous tax rate.

2. Delaying taxable income recognition to a later date can help investors capitalize on the compounding of pre-tax portfolio returns instead of after-tax returns. In progressive tax systems, this strategy can also be advantageous if investors anticipate lower tax rates in retirement. Some examples include;

   • Reducing the frequency of portfolio turnover, which in turn minimizes the realization of capital gains, and;
   • Offsetting a realized capital gain by selling securities at a loss (i.e., engaging in tax loss harvesting).

The key theme among these fundamental strategies is the investment holding period. Portfolio managers should carefully consider portfolio turnover and trade timing. Turnover is often used as a measure of tax efficiency, with low-turnover passive index funds typically being more tax-efficient than actively managed strategies with higher turnover.

However, the relationship between turnover and tax efficiency is not straightforward. While turnover can lead to transaction costs and capital gains tax liabilities, it can also generate tax benefits. For instance, selling an asset at a loss can create a tax offset that can be used to reduce capital gains taxes in the current or future tax periods, although in some regions, such trades are considered wash sales and do not allow for the tax offset.

Question

Which of the following is not a common benefit that investors incur via donating appreciated stock to a charity, in lieu of a cash gift?

1. A tax deduction.
2. Removal of future tax liability from their portfolio.
3. A tax credit.

Solution

The correct answer is C.

A tax credit is different from a tax deduction, and it is an important distinction that level III Candidates will want to be aware of. A tax credit is a full erasure of a certain amount owed on taxes. For example, a $10 tax credit means the recipient will pay $10 less on their taxes overall. A $10 deduction would be much less powerful. It would result in a $10 x (Tax Rate) reduction in overall taxes. So for a 20% tax rate, $10 x (0.2) = $2 reduction.

A and B are incorrect. Both choices are a common benefit since investors will receive a tax deduction (lowering of taxable income in that tax period), which results in a lower tax bill. Investors will also lower future taxes by forgoing the (often large) capital gains tax that would be incurred upon the eventual sale of the appreciated stock.

Reading 8: Topics in Private Wealth Management

Los 8 (e) Explain portfolio tax management strategies and their application