Advisers may be overly focused on helping clients generate as much income as they can from their investments at the expense of another important objective: They're not thinking about how to maximize their clients’ after-tax investment return to generate what in industry parlance is known as "tax alpha."
That was the overarching takeaway from a webinar recently hosted by Financial Planning on ways in which to minimize clients' tax exposure.
Clients retiring with large positions of highly appreciated company stock in their 401(k) accounts, for example, might be eligible for "a special treatment of the tax code" that could potentially save them significantly on taxes, said Patrick Kimbrough, a practice management consultant with HD Vest Financial Services in Irving, Texas. Clients shouldn't automatically roll the stock into an IRA, as they would pay ordinary income tax on the current value of the shares. Instead, Kimbrough said, they might consider distributing the stock to a taxable account, where they would pay ordinary income tax based on the value of the stock when it was first purchased at a lower value.
When clients decide to actually sell the shares, they will pay a long-term capital gains tax on the net unrealized appreciation, or the difference between what the stock originally cost and its market value at the time it was distributed to the taxable account. One of the benefits is that the capital gains tax can be significantly lower than the client’s ordinary income tax rate, Kimbrough said.
SAVING A CLIENT '20 OR 30 GRAND'
"It’s not uncommon for one of our advisers to implement the NUA strategy and save a client 20 or 30 grand," Kimbrough said. For example, Kibrough noted that a 60-year-old client saved almost $16,000 by pursuing the strategy rather than rolling the stock into an IRA
"That's really generating tax alpha," he said.
The higher the client’s income tax bracket and the more the stock has appreciated, the more the client will benefit from the strategy, according to Kimbrough. “[An] NUA tax treatment will work best for taxpayers who have a significantly higher ordinary income tax rate versus their capital gains tax rate,” he said.
Philanthropy-minded clients may also consider tax-efficient ways in which to gift or donate their money. "One of the issues we see regularly is clients giving cash rather than gifting appreciated securities," said Michael Brown, a partner with Dowling & Yahnke in San Diego. Appreciated assets in after-tax and trust accounts are great candidates for gifting, he said, because clients receive a full deduction for the market value of the security and don't have to pay on the capital gain.
CHARITABLE GIVING PAYBACK
Another tax-smart strategy is to make charitable gifts directly from IRAs. Under a rule that was recently made permanent, taxpayers can transfer up to $100,000 of tax-deferred retirement savings to a qualified charity. This is much more advantageous than taking a taxable IRA distribution and donating it because qualified charitable distributions are not included in a taxpayer's adjusted gross income, Kimbrough said.
To make QCDs directly from their IRAs, taxpayers must be at least 70 1/2 and the selected charity must be an organization that qualifies for charitable income tax deductions. Private foundations and donor-advised funds, therefore, would not qualify.
"They're only available for IRAs or individual retirement annuities," said Kimbrough. "SEPs, SIMPLE [IRAs] and inherited IRAs do not have the ability to do QCDs."
To listen to the webinar, click here.