Tax-smart portfolio rebalancing

Offering tax-deferred solutions

An increased appetite for tax-deferred solutions is especially prevalent among high-net-worth (HNW) individuals. With the development of the direct indexing industry, investors can now directly hold a specific combination of the individual securities that make up an index based on client requirements like tax management, ESG investing, or other factor tilts.

The use of direct indexing with affluent and HNW investors is also expected to play a prominent role in the forecasted growth of separate accounts over the next two years.²

Advisors should consider how they can incorporate financial planning into their practice and heighten clients’ awareness of tax implications as part of their value proposition to more affluent investors.² 

Estate taxes and intergenerational wealth transfer

Baby Boomers are estimated to transfer roughly $84 trillion to younger generations, primarily Gen X and Millennials, over the next few decades, which could cause heirs to potentially face substantial estate and gift taxes of 40% or more.

Advisors will need to help clients who receive a sizable inheritance and confidently grasp tax implications, plan retirement, manage their tax burden and estate planning, and provide support with value-added services related to wealth transmission.

However, Millennials are more than twice as likely (73%) than Boomers (29%) to switch between providers, to move assets between firms or to begin working with new wealth managers.⁷ Long-term success serving younger generations will depend on wealth managers’ ability to build a sophisticated picture of individual investors’ mindsets and behavioral traits. 

Upmarket service strategies

Studies show that managing tax implications is one of the most compelling ways an advisor can add value to their clients’ portfolios. As a result, more advisors are talking with their clients about ways to take tax-smart approaches to asset location, transitions between portfolios, household-level management, and tax-loss harvesting.

Uncertainty in future federal estate, gift, and generation-skipping transfer tax rules will drive more investors to rely on their financial advisors to help reduce their tax burdens. RIAs now offer an average of 2.4 advanced planning services, with the most common being tax planning (58%), estate planning (52%), business planning (33%), and trust services (19%).⁸ However, over 46% of affluent investors said their wealth management providers do not offer value-added services, such as tax planning.⁹

Scaling to downstream markets

Certain aspects of traditionally “higher-end” service offerings, such as tax and intergenerational planning, are proliferating downstream slowly, provided they can be offered in a scalable manner.

Wealth management leaders believe the next major disruption would likely come from the mass affluent space, powered by technology to boost productivity and integrate strategies in one place, and shifting the advisor’s role from investment selector to comprehensive wealth coach.¹⁰ An average of 48% of clients receive comprehensive ongoing planning advice, and advisors expect this proportion to increase to 55% by 2026.¹¹ 

Boosting efficiency amid waning new talent

While firms typically rely on adding advisor headcount for growth, they also face talent shortages. Over time, the trend will continue to test traditional wealth managers’ abilities to adapt, compete and grow seamlessly. To overcome talent challenges, firms need to streamline and continuously improve their workflows to enable more trading and money management while increasing margins and controlling operational costs.

Automating rebalancing and trading is crucial to drive operational efficiency and standardized, documented rebalancing techniques which ultimately let your team do more in less time. Freeing up your team to implement your firm’s unique investment management approach, confidently and quickly respond to market movements, tailor, and scale services, and grow the business – without having to add more headcount.

1. Harvest tax losses or gains

With ongoing market volatility, your clients may find themselves sitting on losses that can be harvested to offset capital gains and reposition asset allocation while maintaining their desired portfolio allocations. Rebalancing should allow you to easily harvest tax gains or losses and utilize substitute securities to maintain market exposure while avoiding potential wash sales. It should also provide capabilities for:

• Realizing gains or losses at the position or classification level and holistically across investment portfolios.
• Factoring in restrictions, minimum trade size, and loss or gain thresholds to influence trade recommendations.
• Offering different methods of harvesting gains and losses, including closing the position, selling lots based on cost basis method, and selling specific lots.

2. Set capital gains limits

Avoiding short-term capital gains is the simplest example of a permanent tax savings strategy, while location optimization, which places an investment in the most appropriate type of account to best minimize taxes, can provide both permanent and temporary tax savings.

Establishing capital gains limits can help control your clients’ annual tax burdens by letting you automatically set budgets for short-term, long-term, or combined capital gains based on a dollar value or as a percentage of the overall portfolio.

During rebalances, your rebalancing platform will alert advisors if a trade is at risk of breaching a pre-specified budget, considering short-term and long-term gains, capital loss carryovers, and gains generated from the orders themselves.

3. Optimize asset location

The allocation of various financial assets you set when establishing a client's investment plan may no longer be in line with that plan. Enter rebalancing to realign assets with your client's strategy while simultaneously helping to avoid triggering taxable gains in taxable accounts. Optimizing the location of assets in various types of accounts can significantly reduce the tax impact of the portfolio.

Therefore, rebalancing should also enable you to define location preferences across taxable, tax-deferred, and tax-exempt statuses.

4. Adopt householding models

Householding structures can help you meet clients’ increasing demand for location preferences and tax efficiencies.

Liquidating securities to cash across all those accounts, putting them into a household, and using location preferences to dictate where the securities should be held is a clean-slate approach but may present significant tax consequences. In contrast, a natural drift approach prescribes slowly moving or weighting securities according to the household model as changes in prices or managers occur.

Reviewing a client’s risk profile holistically across all accounts within a household lets you assess the proper alignment between risk tolerances, preferences, and capital gains budgets. To maximize tax efficiencies, a rebalancing system should offer wash sales logic across the household.

5. Use what-if scenarios

Many financial advisors leverage what-if scenarios on model allocation changes or tax-loss harvesting events. Using automated rebalancing, advisors can have the flexibility and power to test different types of capital gains budgets, tax goals, or other scenarios across their entire client base or a subset of clients before following through on trades.

Exploring tax-loss harvesting opportunities and what-if scenarios can help you better position clients for the future.

6. Do year-round tax planning

Experts agree that checking in on clients' investments regularly is key to taking advantage of significant tax benefits. Rather than an annual event centered solely on tax season, apply tax-sensitive rebalancing approaches throughout the year to ensure your clients’ investment policies and tax efficiency goals are consistently met.

Rebalance at least quarterly, harvest material losses during the year, avoid material capital gains distributions and adjust the location of assets in retirement accounts for maximum tax benefit.