How to Calculate An Advisor’s Value: Tax Efficiency

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Allan S. Roth wrote an article for Financial Planning magazine entitled “Calculating An Advisor’s Value.” The article claimed that five different components of intelligent planning decisions comprised the value brought by a smart financial advisor. According to Morningstar, planners can add the equivalent of 1.82% annual return to clients through these five components of what they call “gamma.”

I commented on the introduction and indexed of all five components (plus two additional items) in a previous blog post. In this post I am just going to comment on the second of the five, “Tax Efficiency”, to which Morningstar suggests that advisors bring an additional 0.52% to their clients. Here is how they describe the component:


Here’s a reminder to clients: Investing may be simple, but taxes aren’t. After the asset allocation has been selected, it’s crucial to locate the assets and source withdrawals in a way that minimize taxes.

In general, stocks and low-turnover stock funds are best located in the taxable accounts, while investments taxed at the highest ordinary income rates belong in the tax-advantaged accounts, such as IRAs and 401(k)s. The decision of what to place in Roth accounts is more complex and depends on other factors. You can add value by converting tax-deferred assets into tax-free Roth assets through multiple Roth conversions with possible recharacterizations. This essentially allows clients to buy out the government’s share of tax-deferred assets and, if those assets perform poorly, hit the “undo button” and have the government buy back its share at the original, undiscounted price.

Finally, sourcing the withdrawals is key. A rule of thumb is to use taxable assets first, tax-deferred assets second and Roth assets last. But if the client is in a low tax bracket now but will jump two or more tax brackets later, it may well make sense to pay some taxes sooner at a lower rate.

I’ve written a series of article on choosing the appropriate investment vehicle for tax management. By investment vehicle I mean which types of accounts do you put which type of investments. The quick answer is, for example, to put bonds in traditional IRAs, appreciating assets in Roth accounts and foreign equities in taxable account. In the earliest article from 2005 I divide investments by these three types of accounts and an additional three different dollar amounts (small, medium and large).

I have heard the estimating that putting the right investments in the right investment vehicles produces an after tax appreciation of about 1%  more annually. The added value depends a great deal on your tax situation and your mix of different investment vehicles. The higher your tax rate and the more you have an investment mix which includes Roth as well as traditional IRA, taxable accounts the greater the gain to tax management techniques.

As a quick example, imagine three accounts (traditional IRA, taxable and Roth) with $100,000 each and an asset allocation of 1/3rd in bonds paying 3% interest, stocks averaging 10% (all capital gain for our example) and assets appreciating at 16% (think emerging markets for our example). And imagine that your ordinary income was taxed at 28% and your capital gains was taxed at 15%.

If you tried to immediately spend everything, you would have to pay 28% ordinary income tax on the $100,000 in your traditional IRA account. The other two accounts, having no capital gains yet, would be entirely liquid. Therefore you start the process at year zero with $272,000 of after tax money.

If each account is allocated with $33,333 of each investment, at the end of one year each account is worth $109,667. The entire traditional IRA would be taxed at 28% leaving $78,960. The taxable account would have to pay 28% on the 4% interest from the bonds, and 15% on the appreciation from stocks and emerging markets. In the end it would be worth $108,087 after tax. The Roth would be worth its face value for a total of $296,713 after tax.

But if you invest in a more tax efficient manner you can do better. Imagine investing the entire traditional IRA in bonds paying 3%. At the end of a year it would be worth $103,000 and after paying 28% tax that would leave $74,160. The principle is: Put bonds which are taxed at ordinary income rates in the account where all the growth is taxed at ordinary income tax rates anyway. And put the slowest growth in the account which has the highest tax rate.

Then imagine that the entire taxable account is invested in the stocks appreciating at 10% annually. At the end of one year the account would be worth $110,000. After realizing the $10,000 gain and paying $1,500 (15%) capital gains tax you would be left with $108,500.

Finally the Roth account is entirely invested in stocks with the highest appreciation of 16%. At the end of one year the account would be worth $116,000 and you would be able to spend it all tax free.

Your final after tax value would be $298,660 which is $1,947 more than the asset allocation evenly split across all three account. This is 0.72% of your original $272,000 additional after tax growth in a single year. Additional years compound this effect.

And in addition to putting the right investments in the right investment vehicles, a Roth conversion or Roth Segregation accounts also reap large tax savings. Growth after the conversion is tax free growth and if the account goes down you can recharacterize and undo the conversion.

Finally not only is making your lifestyle withdrawals from the correct accounts save on your taxes, but leaving each type of account to a different aged family member can boost estate planning tax benefits.

Again, I’m surprised that they list these techniques as only contributing 0.52% additional return. Taking advantage of all of these should boost after tax returns significantly.

Here is an index to the entire “How to Calculate An Advisor’s Value” series.

And here is a link to having us help you with your comprehensive wealth management.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.