It's dismal enough paying taxes when the economy is vigorous and sane. Doing so in yet another year when some portfolios are down 40% to 60% "really ticks clients off," as one planner puts it. Worse, this double whammy has more than one advisor-client on the edge of his risk-tolerance seat with a finger on the sellout button. The trick for planners is not only to assuage their charges' fears by praising the wonders of diversification, but to show clients that their losses can be manna from tax hell–and then make it happen.
While a judicious review of client portfolios can yield opportunities for the implementation of effective tax-saving strategies, with a watchful eye toward surprisingly common pitfalls (which we will examine below), many planners maintain that harvesting losses this tax year is the key to it all. Advisor Bruce Primeau is one such believer who knows the concept isn't always easy to convey. "Initially, it's hard for clients, even CPAs, to see," says the former CPA who "did time in public accounting" and who now is director of Wealth Management Services at Wade Financial Group in Minneapolis, Minnesota, a fee-only firm that focuses on small business owners. "You're working these losses, you're making these moves, and they're saying, 'Okay, but where's the pot of gold at the end of the rainbow?'"
Believing there is no pot, some clients rush to stash their money in cash, in money market instruments, not realizing that by moving themselves out of a capital-gains tax treatment context they are subjecting themselves to ordinary income gain treatment. "By making that move they are automatically giving themselves a tax increase," says Primeau. "You sell stocks and bonds–they have long-term treatment–you get the 20% rate; any interest income that you get is taxed at the ordinary rate; so if you're in the 40% tax bracket, you just lost 40%." He cautions clients against making tactical moves over strategic moves, and warns that attempting to time the market is a fool's errand indeed.
Tax strategies deployed on behalf of a client are in considerable measure dependent ultimately upon the client's financial personality. For example, experience has shown Wade Financial that its clients fall into three general areas, areas undoubtedly applicable for advisor clients everywhere. Clients in Group A are those not as concerned about the market as the average man on the street (they let their advisors do the worrying for them). Primeau explains that the recommended strategy for Group A clients is to "hang tight" and stick to their long-term investment horizon. Group B clients comprise those who are "somewhat" concerned. For these clients, Primeau is not against them making a 20% move down in equities, say from 60% to 40%. Group C are those persons "overwhelmingly concerned" (Wade Financial has had few of those, Primeau concedes), and who wish to make a 40% or greater shift towards bonds. Such clients are immediately called into conference.
The Big Picture
Being right when it comes to tax planning can be challenging. Most independent financial advisors outsource their client tax preparation needs, though there are exceptions. Pat Konetzny of The Practical Advisor in Maynard, Massachusetts, prepares the majority of her clients' taxes, as do most of the other advisors in the Alliance of Cambridge Advisors, a network of personal financial advisors, of which Konetzny is a member. Tom Orecchio ,of the wealth management firm Greenbaum and Orecchio in Oradell, New Jersey, outsources his client tax preparation and works closely as the "financial quarterback" with the client's accountant "to get it right."
Communication is vital, Orecchio says, because while the planner doesn't always see the big picture from a tax perspective, the accountant does. For example, a client may incur capital gains from something outside his investment portfolio. "We'll go back to the accountant and say, hey, is there anything that is unique about the client's tax situation this year that might impact the way we manage the portfolio? And we let the accountant make that decision," says Orecchio. With the exception of the past few years, Orecchio has rarely received a call from a client's accountant regarding investment performance issues. Now the phone is ringing more often.
The phenomenon from the accounting perspective is of special interest. Ginger Broderick, a CPA who runs a small accounting business in New York that specializes in fine art and taxes and occasionally writes for Investment Advisor, agrees that there is much more interaction between accountant and planner. "I probably talk to my planner a couple times a week and run through our client base," she says. "He gives me an update on anybody that called him, and on areas of concern that we might have." It is to the planner's benefit that he work more closely with her, Broderick adds, because she is then more likely to refer him to her clients.
Ongoing communication between advisor and client in regard to tax matters is vital, too. For the past two years Orecchio's firm has sent to clients a special report detailing anticipated capital gains from their mutual funds, showing how those anticipated gains will affect each client specifically. "The report looks at a very client-specific issue," he says. "Rather than just saying this fund's going to pay out 30 cents a share, we show them exactly what it means to them. And with that anticipated report, and with their unrealized gains and loss report, they could do offsetting trades, or make [other] tax-motivated trades. We'll work with the accountant and the client to figure out how to reduce the taxable bite."
Curt Weil, of Weil Capital Management in Palo Alto, California, has clients sign a letter of permission that allows Weil to discuss his clients' financial affairs with all concerned parties, "something we do regularly," he says. Primeau notes that for the past several years Wade Financial has had in place a year-around service for tax planning–not tax preparation, which is jobbed out. "It's designed to help small business owners or people who have high income year after year, who have paid taxes through the nose, and who don't have a clue on how to shelter some of it," he says. Their accountants often don't either.
Like Orecchio, Primeau looks at the "big picture" with an eye toward tax control, something that tax preparers aren't necessarily prepared to do, he says. As noted, Primeau is himself a CPA, as is the firm's manager of tax planning services. "Nothing against CPAs, but we're not great forward-lookers," Primeau says. "We're great at preparing taxes, we're not great at tax planning. By preparing a tax return, how do you add value? You don't. It's historical. You're reporting. You've got to go beyond that." Since leaving his work as an accountant to become an advisor he's found himself taking "more of a look from the top, getting under the hood, so to speak, to see what opportunities exist for a given client–and doing much more work up front." Primeau gives this simple but common example: a client comes to him showing a $300,000 W-2, with lifestyle spending of $100,000–and yet he's paying a 39% ordinary income tax rate. At a meeting with the client and tax preparer, Primeau will suggest putting a portion of the unspent money into some type of deferred vehicle through the client's business, in order to save taxes and plan for the client's retirement.
Time to Recharacterize
Tinkering with Roth IRAs is a common tax strategy this year. Like many advisors, Weil combs through client portfolios to see if it makes sense to "recharacterize" their existing Roth accounts. Here's how it works. Let's say that in 1998, the year the IRS bestowed upon investors the option to pay their tax bills over four years, a client converted a sizable IRA to a Roth IRA. Assuming the client was on a tax return extension, he had until August to perform this recharacterization–an IRS term meaning, in effect, to reverse the conversion. Let's give that 1998 conversion of an IRA to a Roth IRA a value of $500,000. Because of the bear market, today that Roth is down 30%, to $350,000. But also today, if the client recharacterizes, he can get back all the tax money he paid out on the $500,000 value, wait 30 days, and convert the account again at the lower rate. How much lower? Assuming the client was in, say, the 31% federal bracket when he converted, his tax cost was about $150,000 over four years. By recharacterizing, he gets back the $150,000. Thirty days later he can "Roth-ify" the IRA again, and his tax bill will be $105,000. In rough numbers the client saves about $45,000. "Nice move, isn't it?" asks Weil. He adds that, unfortunately, his accounts on average are up 8.5% from December of 1998, thanks to the strict adherence of a diversified-by asset-class strategy.
Sometimes, however, it makes good tax sense to close a Roth IRA account, especially if the investor owned Enron or similar equities that are worthless or nearly so, and the account itself becomes worthless. The tax angle is to sell out and grab whatever assets are left, and take a tax loss as a miscellaneous deduction, subject to the 2% floor in miscellaneous deductions. But it's not always that simple, cautions Alan Weiner, a CPA as well as a J.D., L.L.M., senior tax partner at Holtz Rubenstein & Co. in Melville, New York, and occasional Investment Advisor tax columnist. Myriad factors are at play, all arising from the uniqueness of each client's financial situation, making generalities about the advisability of selling out of Roths imprudent. That said, it's safe to say there can be negative tax ramifications if the investor hasn't had the account for five years, and that if the taxpayer is subject to the alternative minimum tax (AMT), that miscellaneous deduction won't do him any good at all. Accepting the viability of closing a Roth, it is vital that the taxpayer, whether he set up a Roth IRA or converted a traditional IRA to a Roth IRA, knows what his tax basis is. This may sounds obvious, but Weiner says that's not often the case. "I don't think taxpayers are aware," he says. "I don't think anybody ever expects to close these things and take losses, so I'm sure nobody's keeping track of their basis."
When it comes to money and taxes, there is much that is not obvious. Primeau finds it necessary to keep reminding his more short-sighted clients that for the better part of the past decade they were realizing capital gains, whether from stock sales or mutual funds, with no way to offset those gains due to a runaway bull market. Primeau will tell clients: Now you can use market loss as an anecdote to gain. Plan to sell your dental practice in order to retire? Guess what? That sale is a capital gain. Got this rental property that you're looking to get out of? That rental property, fully depreciated, is a capital gain. Primeau believes an advisor can never do enough coaching with clients, especially those with an inflexible mindset. "What do you do with those capital gains?" he'll ask rhetorically. Well, here's what you'll do with them in the absence of loss on your tax return: you'll pay taxes on them. Says Primeau: "We're trying to find ways to get creative in using these losses versus just plunking down the allowable $3,000 [deduction] each year and hoping we and the client live long enough to use all his capital losses."
Carry-Forward
Getting creative with mutual funds that have tanked is high on advisor Weil's agenda this tax year, the result of a client-portfolio tax-review process that was underway in his office by mid-July. When appropriate, he's been busy switching clients out of some funds and into other similar funds with embedded tax-loss carry-forwards. What clients get with this is "twice the bang" for their lost bucks, Weil says.
In explaining to clients how the tax-loss carry-over procedure works, he makes sure they first appreciate that part of the tax code that dictates that mutual funds, and therefore the mutual fund companies that offer them, must distribute at least 95% of any realized gains, along with interest or dividends, in order to avoid being taxed. "This is why a lot of people were irritated in the year 2000," Weil says. "They bought funds that finished down substantially but still got hit with a capital gains distribution." Today, if a client's fund has a realized capital loss, the only thing he usually can do is warehouse it until he has gains to offset it. In other words, investors have to distribute the gains that they've realized but can't distribute the losses they've realized.
There's a simple solution: switch funds. Weil uses the example of a client invested in the Vanguard S&P 500 Index fund (VFINX), which is down 21% so far this year alone (as of September 13) after losses of 9% in 2000 and 12% in 2001. Weil sells the fund, enabling the client to use the loss to offset capital gains dollar for dollar, with no limit. (Any excess can be applied to up to $3,000 of ordinary income. Any leftover loss can be carried forward indefinitely, terminating upon death.) The real question, relative to Weil's illustration, is what is done with the money taken out of the Vanguard 500 fund? "As an example, we'll buy an index fund," he says, "such as Nations Large Cap Index/Primary A (NINDX), which has a 31% capital loss carry-forward. So not only does the client realize the loss on the existing Vanguard position for this tax year, but the next 31% of gains in that fund (assuming Large Cap comes back sometime in the near future) will be tax free, since the fund can only use the capital-loss carry-forward to shelter capital gains in the future."
