Tag Archives: Tax Alpha

Why Congressionally-mandated FIFO accounting will adversely impact your clients – and what you can do about it.

This past Saturday morning, the Senate passed their version of the Tax Cuts and Jobs Act bill. One of the lesser known provisions in the Senate bill, was the elimination of an investor’s choice to identify which shares of securities they may wish to sell or donate. The provision states that the only way securities may be disposed of is through use of an accounting method commonly referred to as First-in First-Out (FIFO) where the oldest shares purchased are the first ones an investor may sell. Because of the protracted appreciation of the securities market, the first shares purchased are likely to be the lowest cost and therefore carry the most gain (and resulting tax penalty).

The House version did not include this particular provision. And because there exists so many differences between both versions of the bills, this past Monday, Congressional Republicans went to a Conference Committee to begin reconciliation efforts on the various differences between the two tax bills. Led by House Ways and Means Committee Chairman Kevin Brady, and Senate Finance Committee Chairman Orrin Hatch, there are a number of hot topics that will need to be negotiated – including individual tax rates, the handling of AMT, child tax credits, corporate tax rates and repeals to the Affordable Care Act.

Because of the number of big-ticket and high visibility items included in the bill coupled with the pace the legislation is advancing, some experts fear that the FIFO provision may be overlooked and ultimately absorbed into the reconciled bill as collateral damage to bigger-picture negotiations.

However, we at Adhesion believe that this would be shortsighted as the provision is damaging to the very investors and savers that it is purports to protect. The provision has virtually no impact on the $1.7 trillion funding gap the bill creates as it is currently scored at generating just $2.4 billion over 10 years. As inconsequential as those revenues may sound they don’t even consider the expense side of the equation – no official estimates exist thus far on the offsetting expense associated with infrastructure retrofit needed to operate, report, comply and monitor the changes thrust upon the industry. And it certainly does not consider expenses associated with policing and adjudication of these matters.

Interestingly, the Investment Company Institute, the powerful lobby representing the mutual funds and ETF industry, were granted an 11th hour carve-out reprieve in the Senate bill to allow mutual funds and ETFs to continue to sell specific tax lots within their pooled investment vehicles. It is important to note this carve-out exemption for institutional investors does not extend to those retail investors purchasing and selling these instruments, only how the fund itself accounts for the gains and losses within their portfolios.

We feel there are some other anti-competitive and unwarranted elements in this provision that members of Congress, investment advisors and end-investors should be gravely concerned about. Specifically –

  • When the Senate proposed a carve-out provision that protected the institutional fund companies and ETF providers while ignoring the retail investor class, they created an uneven playing field that is heavily tilted against retail investors. Through this provision, the institutional investor will be afforded a significant advantage as they may exit any tax lot they wish. With the freedom to select tax lots, the institutional investors can sell at will, whereas the retail consumer will be locked-up due to tax costs associated with their low-basis FIFO shares. This sort of unfair playing field is analogous to suggesting institutional investors can trade commission-free yet retail investors must always pay commission. The provision creates an enormously unfair and artificial trading barrier that will heavily disadvantage retail investors.
  • With this barrier in place, end-investors will likely open up different brokerage accounts or have paper certificates issued to them. In both cases, there is no reasonable method to enforce or monitor for this type of behavior. This will drive up operational costs for advisors and custodians which will ultimately be passed through to the end investors. And by exploiting this loophole, the revenue projections for this provision are likely to fall even shorter than expected.
  • By adding friction to the retail investor’s ability to liquidate securities through a FIFO provision, one should assume that there will be less selling – which leads to less liquidity and efficiency in our capital markets. This also means that retail investors will be less inclined to eliminate assets in an attempt to seek diversification. This will ultimately lead to concentrated and highly appreciated holdings in client portfolios which runs in stark contrast to tried and true investment principles of diversification, rebalancing and buy-low/sell high for retail investors. This introduces the potential of an enormous loss during a market correction as well as introducing excessive levels of portfolio risk – all while stifling the efficiency of the capital markets.
  • This provision disproportionally burdens older investors who likely have a more extensive tax history and on average maintain a lower cost basis than younger investors. This FIFO tax also represents an unplanned expense that retirees had not budgeted for – which will erode retirement savings at a time when retirees have very little time to recoup this new, unanticipated retirement gap.
  • This provision also disproportionally disadvantages middle- and upper-income investors who are more likely to hold FIFO-eligible securities. Contrast that with ultra-high net worth and institutional investors who frequently hold real estate, hedge funds and other sheltered ‘accredited investor’ assets, which can be exempted from FIFO provisions as a result of the Senate’s proposed carve-out clauses.
  • Lastly, if legislation is advanced, one unintended consequence facing mutual funds and ETF providers is that retail investors will likely seek to avoid concentrated positions so as to have more choice on which shares to dispose of. Mutual funds and ETFs are pooled investment vehicles, and as such, they are generally far more concentrated in a client portfolio than individual equities. We believe advisors and investors will wisely consider diversifying out of concentrated mutual fund and ETF holdings into a larger basket of diversified equities so as to have multiple tax lots to sell. So rather than purchase Coke multiple times, an investor may consider purchasing Coke, Pepsi, Dr. Pepsi and Constellation Brands. Security prices and equity valuations may no longer be dictated based on rational, sound fundamentals, but rather from a desire to exploit loopholes in heavy-handed government legislation.

For a bill that is intended to promote simplification and fairness, we think it does just the opposite. It unfairly penalizes the retail investor with a FIFO tax while introducing liquidity friction and complicated recordkeeping. At the same time, it rewards the large institutional and ultra-high net worth investors with flexibility to use their own preferred inventory accounting methods. Most would argue that if framed properly and viewed in its totality it would be difficult to defend.

So what can you do? We think this particular provision just needs a bit of sunlight so that it can be evaluated and debated in the open. With enough voices we think we can make this happen and we encourage you to get involved.

First off, encourage your clients to take action.  Consider directing them to TD Ameritrade’s Legislative Action Committee site, which has done a fantastic job of highlighting the issue.  From this site, they may contact their local representatives .

Next, as investment fiduciaries we would urge you to read the Money Management Institute’s position on the Senate version of the tax reform legislation.  On their site, the MMI chairman, Craig Pfeiffer shares talking points and a number of template letters you can use to contact your elected officials.  Similarly, the Investment Advisor Institute – an advocacy group for SEC-registered investment advisory firms has developed a site to contact elected officials and communicate your concerns of FIFO legislation.  Adhesion has also drafted an open letter to Congress which can be found here.  Feel free to use it or modify it and share it with your elected officials.

Also, as we head into year end, consider generating losses through active tax harvesting.  These losses can be used to unwind concentrated mutual fund or ETF holdings or buffer against future taxable gains resulting from potential inflexibility associated with this bill.  For more information on the value of tax harvesting and how it can add value to a client portfolio, feel free to watch this webinar

Lastly, we think now is a good time to dump concentrated mutual fund and ETF holdings to spread those proceeds into a diversified pool of equity holdings.  If you are interested in active equity managers, please consider Adhesion’s Asset Manager eXchange which can be found here.

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Capital Gains Opportunity to Add Tax Alpha

Many advisors are currently in the process of selling off stocks; some as a precautionary measure as major equity indexes reach record highs, and others to rebalance portfolios by trimming the fat. The catch is that, thanks to a six-year bull market, many clients hold appreciated stocks that trigger taxable gains when sold. The upside for advisors is that these unavoidable taxable events present great opportunities to show their clients tax alpha. Or, as Financial Planning puts it, “How can advisors sell stocks and avoid a painful tax bite?”

The traditional way to offset these taxes is to balance portfolio gains with losses. However, many losses leftover from the 2008-2009 crash have been used up. Financial Planning offers advisors several approaches for adding tax alpha through offsetting clients’ capital gains. For one thing, advisors can utilize technology to optimize rebalancing processes. Says Lance Gunkel, COO at Sherpa Investment Management in West Des Moines: “We utilize a rebalancing tool that uses algorithms to come up with the most tax-efficient way to rebalance or get out of positions. In the current environment, this may mean taking offsetting losses in other asset classes, such as emerging markets debt and international equity.” Advisors seeking losses should also take a look at energy stocks due to plunging oil prices.

Advisors should also counsel clients to consider charitable contributions. As long as a share has been held longer than one year, the donor can get a tax deduction for its full market value. This way, clients can hold onto the cash they might otherwise have donated with the added benefit of offsetting capital gains.

Sue Stevens, an advisor out of Deerfield, Ill, suggests approaching retirement distributions as a way to minimize taxes. Says Stevens: “One tactic I’ve been using lately is doing 15-year tax projections for clients in early retirement. There may be opportunities to take IRA distributions or do Roth conversions in years when taxable income is low. They can also recognize significant capital gains.” Gain harvesting is another way to minimize tax hits; it’s especially effective for investors with more modest incomes. With this strategy someone can sell an appreciated security and realize the gain without incurring any additional tax.

Advisors looking for continued growth and new ways to stand out from the competition should be evaluating how they can assist clients with tax issues. Adhesion is in the business of powering advisor alpha, so we already have powerful solutions in place to help you add tax alpha. Check out this short video to learn more.

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Advisors: Embrace the Client’s 1040

There’s no question that taxes and tax policy are front of mind for many of your clients – many have just experienced their highest capital gains distributions in years. This is a prime time to demonstrate your value to clients by adding after tax value to their investments.

Many advisors are hesitant to discuss a client’s tax return. Get over it! At this point you might be asking yourself: doesn’t my client already have a CPA? While this is likely the case, as ThinkAdvisor points out you as the financial advisor may have the stronger value proposition that appeals to the higher- net worth client. At the very least you can play the role of quarterback and coordinate the team of advisors assisting your client; provided you can identify the appropriate tax benefits and problems.

According to this ThinkAdvisor article, a great way to do it is by reviewing your clients’ tax returns and suggesting changes. Here are some of the relevant tax issues that ThinkAdvisor recommends going over with your clients.

Line 8a: Taxable Interest

If the client has a large amount of taxable interest and/or is in a high tax bracket, consider replacing some of their taxable investments with tax-exempt vehicles.

Line 9b: Qualified Dividends

Remember that ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at your client’s capital gains rate (20%, 15% or 0%).

Line 13: Capital Gains

If your client has a substantial amount of capital gains and/or any capital loss carryforwards, they may be able to use the losses to offset their capital gains for the current year. If there are no capital gains, or there are capital loss carryforwards remaining after eliminating all capital gains for the year, up to $3,000 of the carryforward can be used to offset ordinary income.

Line 15: IRA Distributions (and other retirement plans)

Line 15a includes the portion of the IRA distribution that is not subject to income tax. Line 15b is the portion that is taxable. If the distribution as a percentage of the total IRA is too high, it could cause your client to prematurely exhaust their IRA. You might want to advise them to consider a Roth conversion; especially if they don’t have to have the income.

Line 20: Social Security Benefits

Line 20a contains the total amount of Social Security received. Line 20b is the amount that is subject to income tax. The amount that is taxable is determined by the taxpayer’s filing status and modified adjusted gross income (MAGI).

Tax Alpha isn’t just about income tax returns. Enter the Adhesion Advantage. The Adhesion Advantage lets high-performing advisory firms save time and resources by automating key tax aware strategies. The tax-aware investing process becomes a lot more efficient when incorporated with Adhesion’s technology and overlay managers. The Adhesion Advantage significantly augments advisors’ ability to add tax alpha and show clients real value.

Check out this short video to learn more.

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Delivering Tax Alpha

Income taxes increased this year for your most successful clients.  When you consider that we’re in the 5th year of this bull market, there are many potential unrealized tax traps hiding in clients’ portfolios.  These create opportunities for you to deliver more alpha to your existing clients and attract new clients with your ability to deliver more tax Alpha.

The challenge is how to manage a tax aware program across a number of clients and accounts.

This was the subject of Adhesion’s “Delivering Your Investment Alpha” webinar. View the replay below of “Delivering Tax Alpha” presented by Barrett Ayers, Chief Solutions Officer at Adhesion Wealth Advisor Solutions.

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