How to Add Value by Reviewing Clients’ Tax Returns

That leads me to steer the client to a more conservative asset allocation since it will be hard for that client to rebalance after a significant decline. If the client insists on a more aggressive allocation, I try to negotiate and get them to agree that they can increase that allocation only during a bear market. I’m not trying to time the market; I’m testing their behavior.

2. Marginal tax rates. I start with their taxable income (adjusting for changes in the current year) to get marginal tax rates for ordinary income and long-term capital gains, including whether the 3.8% investment-income tax applies.

This helps me help the client in many ways. For example, should the client be holding tax-exempt municipal bonds and bond funds? Often, the client can earn more after taxes with less risk by owning a taxable bond or bond fund. And if the client is in a high-tax state, even a two-year Treasury bond is paying 2.70% (as of April 22, 2022), and its interest is state-tax exempt.

Then I look at long-term capital gain rates. The client may be in zero percent marginal tax rate if they have a tax-loss carryforward. That carry forward has value in future years, so I’m careful only to use it to sell more expensive, inappropriate investments. There is another reason the client might be in the zero percent federal long-term capital gains bracket. That’s if the taxable income is very low; this is more common when the client has retired but hasn’t started taking Social Security or withdrawals from tax-deferred accounts. In 2022, a couple filing jointly can have income up to $83,350 net of any deductions. The 2022 standard deduction for that couple is at least $25,900, so the client can have $109,250 in taxable income and still be in that zero percent long-term capital gains tax-rate. This income includes those gains recognized and states typically will tax that long-term capital gain.

3. Tax-deductions. With state and local tax (SALT) deductions limited to $10,000, the value of the deductions is less. More people take the standard deduction. But even if they itemize, the deduction is less valuable. Say the couple will reach the $10,000 maximum SALT deduction in 2022 and have $20,000 in mortgage interest. They itemize, as the $30,000 in deductions is higher than the $25,900 standard deduction. But only that last $4,100 provided any tax benefit. Meanwhile, bond income in the taxable accounts is not only taxed but may be subject to the 3.8% investment income tax. Assuming the client has enough liquidity, I tell clients that it makes no sense to lend money out (bond) at a lower after-tax rate than they borrow at (mortgage).

4. Tax-efficiency of holdings. I look at the realized capital gains on the return. Investments in the taxable account should be very tax efficient. Broad index funds generate little to no capital gains, and the best location for tax-efficient investments is in the taxable account. But sometimes I see large capital gains, even when the client didn’t sell the fund. For example, the once-hot Sequoia mutual fund (SEQUX) has been passing through huge capital gains for many of the past several years. In 2021, it distributed well over $22 a share in gains, which was more than 12% of its NAV. This is because of what I call the “death spiral.” Poor performance causes investors to pull their money out, forcing the fund manager to sell assets they have held for years, which passes the taxable gain on to the shareholders who didn’t sell. Even though Sequoia performed well in 2021, investors still yanked money out as they didn’t like paying the taxes. I call this the mutual fund tax-trap.

Yet another telling sign of opportunities to improve tax efficiency is if the client has very high interest income on schedule B. I look at holdings in their tax-deferred accounts and point out that less tax-efficient holdings generally belong on a tax-advantaged account. If they own stock funds in their tax-deferred accounts and bonds in their taxable account, it’s easy to fix. Just sell the bond fund in the taxable account (typically very little gain and perhaps even a loss) to buy a stock index fund. Then do the opposite in the tax-advantaged account. But asset allocation should always come before asset location. Even CPAs typically get the asset location wrong. My tax-deferred accounts are all in fixed income but, to hit my overall allocation, I have some fixed income in my taxable account as well.

5. Discipline in trading. Investing should be disciplined and not changed constantly. One can have very tax-efficient holdings but still churn the portfolio. This is behaviorally related but, in such a strong market overall since 2009, they may not have a tax-loss carryforward, but instead have large capital gains taxes from the churn. This is especially concerning if the gains are short-term because they show more extreme behavior. Plus, those gains are taxed at a higher rate.

I look at schedule D to see when clients bought and sold the holdings. The data is compelling since the higher churn is negatively correlated with performance.

6. Investment returns. If the client passes the test on recognizing little in the way of realized investing gains, one way to get an indication of performance is to look at unrealized gains. For example, over the 10-year-period ending on April 22, 2022, the Vanguard Total Stock ETF (VTI) earned about 264%. Some came in the form of dividends, but there would be some huge unrealized gains. If the client doesn’t have huge unrealized gains today on stocks or stock funds, they are doing something wrong and not getting close to the return of the market. This isn’t as good as calculating the internal rate of return of the portfolio, but rarely do I see this any longer on brokerage statements. The reason is obvious; the firms don’t want clients to compare their returns to the appropriate benchmarks.

7. Charitable giving. Donating to charities is a personal decision and I don’t advise clients on how much to give or what charities to support. But I do advise them on the most tax-efficient way to give. If their tax return shows me that they are making cash contributions to charities, I point out a better way. That way is making lumpy contributions of the most appreciated securities with long-term gains to a donor advised fund (DAF).

If, for example, the client had been giving $10,000 cash per year, they may not even be getting a tax benefit as it’s only getting them to the standard deduction. A far better way to contribute is taking the securities with the largest percentage long-term gains and contributing $50K of those most highly appreciated securities to a DAF (assuming it’s less than 30% of AGI) and then having the DAF distribute to those charities over the next five years. This both avoids paying taxes on the unrealized gains in the securities and maximizes the tax benefit from the contribution as the client only has to reach the standard deduction in one year versus all five.

Summing it up

I learned investments in business school in a theoretical way assuming there is no tax “friction.” But taxes are real and erode returns.

These are a sampling of things I can do for clients to create tax-alpha. Often I need to test tax implications of changes with the client’s CPA. They typically have the tax return in a software program and can easily run some scenarios to see the taxes currently being paid offset fees and taxes later. They can estimate the tax impacts of various changes.

I’ve always said investing is simple; but I never said taxes were. Building tax-efficient portfolios and strategies from the client’s current portfolio is the single most valuable thing we can do for our clients. It’s a key way to differentiate ourselves from robo advisors.

And the clients’ CPAs typically appreciate being in the loop and part of the process. What’s in it for you is that your client will appreciate what you are doing for them so much that they will refer others to you. Their CPAs may as well.

Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multi-billion-dollar companies and has consulted with many others while at McKinsey & Company.

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