This paper highlights the importance of active tax management of investment portfolios, using the results of an actual Ballentine Partners’ client as a case study. While the strategies and results described are real and verifiable, other details regarding the client have been altered to protect confidentiality.
During the period covered by this study, we were able to add approximately $18.8 million of value for a $300 million portfolio (inclusive of a concentrated stock holding) through the combined impact of (1) strategically locating assets to save gift tax, estate tax, and generation skipping tax and (2) active tax management of the portfolio.
Active tax management means managing a portfolio to achieve an optimal net return after all taxes and fees. In any given period, it is likely that portions of a diversified investment portfolio will experience gains while other portions will experience losses. That is the nature of a well-designed diversified portfolio – the returns of the portfolio components are intended to be uncorrelated (some investments will have positive performance while others will have negative performance over the same time period), while the overall portfolio is expected to produce gains. The income tax code allows an investor to offset realized losses against gains that are realized later. In other words, it is possible to “bank” losses against future gains to protect those gains from being subject to capital gain tax, however, doing this is not easy. Active tax management requires a high level of attention and skill on the part of the portfolio manager. It also requires collecting and analyzing information about the client’s tax situation throughout the year. In order to do this, we had to create our own systems and, as far as we know, no other wealth manager has attempted that.
In this example, we were able to effectively zero out all of the clients’ income taxes through active management. From 2006-2014, the pre-tax and after-tax return portfolio returns were essentially the same. In fact, for most of the period the clients’ after-tax return slightly exceeded their pre-tax return when the present value of the deferred tax-savings available to them is taken into account.
Most private investors are aware of the importance of strategic asset allocation, but few are aware of strategic asset location as a wealth-creation opportunity. Strategic asset location involves making tactical decisions about ownership structures and aligning various types of assets with those ownership structures to achieve outstanding investment results after-tax across generations of a family. In this type of planning, income taxes, gift tax, estate tax, and generation-skipping tax must all be taken into account.
In this case, our asset location strategies allowed the clients to move $27.3 million of assets out of their estate, which saved the family about $16.4 million in eventual estate taxes, incurring no gift tax to achieve this result. The clients held a concentrated position in a single stock which we utilized to fund a series of Grantor Trusts. They also used a combination of cash and securities to fund an education trust for future generations and a trust for the benefit of grandchildren. Using the annual gift exemption amounts, the clients made outright gifts to certain individuals and assisted with the funding of the education trust and grandchildren’s trust.
Keep in mind that this analysis concerns just one client and the results described here are unique to that client. The selection of this particular client was based on the following factors: (1) the author of this study wanted to do the analysis and found the time to do it and (2) the author was able to assemble all of the data for this client necessary to perform this comprehensive analysis. Selection of this client was not based on the client’s net investment returns. The analysis is based on the clients’ personal portfolio and trusts on which the clients pay income taxes. We excluded all other family entities. We also excluded private investments and the clients’ concentrated stock position.
About the clients
Jack and Ellen Rodgerer (not their real names) have been clients of Ballentine Partners since 2005. Jack is the founder and CEO of a publicly traded company. 77% of Jack and Ellen’s total family assets are invested in the stock of the company that Jack founded. The Rodgerers have two children under the age of 18. Their wealth management objectives are:
- Maintain a liquid pool of assets outside of their single public company stock position that the Rodgerers can access.
- Transfer wealth to their children during the lifetimes of Jack and Ellen and provide wealth to future generations that have not yet been born.
- Be thoughtful about ways to utilize their concentrated stock position for wealth transfer.
- Cover the education expenses for the next generations of the family as well as nieces and nephews.
- Pass as much wealth as possible to future generations. That means minimizing estate, gift and generation-skipping taxes by integrating estate planning and investment strategies.
- Surround the family with a highly capable team of professional advisors in order to maximize the value of their advice and other services.
This case study begins in June 2006, when we started to manage the portfolio, and it ends with 2014 because that is the last full year for which we have income tax data. The tax savings were due to either strategic asset location or active tax management.
Strategic Asset Location
The following chart shows the estimated cumulative tax savings realized by the Rodgerers as a result of our advice related to strategic asset location. The cumulative total tax savings were approximately $16.4 million.
During the period covered by this study, we assisted the client in creating five Grantor Retained Annuity Trusts (“GRATs”), each funded from the client’s concentrated stock position. Four of the five GRATs were successful, generating a residual gift value at the time of transfer of about $14.7 million. Given current values of these assets after significant growth, the estate tax savings are over $13 million. (When a GRAT is not successful, the stock the client contributed to the GRAT is simply returned to the client. No value is lost in a failed GRAT.)
Jack and Ellen also funded a trust specifically to pay for the educational expenses of various nieces, nephews, and family friends. By utilizing both annual and lifetime gifting exemption amounts, they contributed cash to the trust and saved $179,000 in taxes. The Rodgerers created another trust to benefit their unborn grandchildren which saved roughly $2.3 million in estate taxes by utilizing both annual and lifetime gifting exemption amounts. When choosing assets to fund this trust, more illiquid, long-term investments were selected to match the long time horizon for this entity. The tax savings calculations are based on the value of the annual exclusion each year as well as any growth of the assets since inception.
The Rodgerers have also made effective use of their annual exclusion gifts to transfer wealth efficiently. Annual exclusion gifts have been used to help fund the education trust and grandchildren’s trust as well as providing gifts to both family and non-family members. This combination of strategies allowed the clients to fulfill one of their major goals – to provide financial assistance to family members and friends in a tax-efficient manner.
Lastly, we advised the Rodgerers to have all of the trusts be structured as Intentionally Defective Grantor Trusts. This means all taxable events in these trusts flow through to Jack and Ellen’s tax return as an added way to reduce their taxable estate by paying the tax liabilities for the trusts as well as allowing the trusts to grow tax free for the beneficiaries.
Active Tax Management
Active tax management requires very frequent portfolio reviews to capture losses when they occur. We sell the loss position and then immediately reinvest in a security that is similar enough so there is no change in the client’s strategic asset allocation, but different enough not to trigger the “wash sale” rules under the Internal Revenue Code. As part of our typical portfolio rebalancing, we monitor the unrealized gain/loss of the positions in our clients’ portfolios and execute these types of transactions when appropriate. The Rodgerers benefitted greatly from this strategy, as a total of about $8 million of losses were harvested from 2006-2014, generating tax savings of about $2.4 million.1
Because of this strategy, as well as Ballentine Partners’ overall tax efficient investment strategy, over that time period, the Rodgerers’ annualized after-tax return of 2.53% essentially matches the annualized pre-tax return of 2.55%. These results also include over $5 million of liquidations ($350,000 of realized gains) in the portfolio in 2013 and 2014 to make distributions of cash to the client. Therefore, over the 8+ year period, the portfolio did not generate any tax liability for the Rodgerers while both the pre-tax and after-tax returns are in-line with the benchmark for the portfolio.
The value that can be added through optimal tax management can be significant for clients. The Rodgerers were able to benefit from both asset location and active tax management of investment assets and, in total, saved $18.8 million in taxes through these strategies. Optimizing a client’s tax situation is an ongoing process and although the Rodgerers have benefited greatly from the strategies they have already implemented, Ballentine Partners continues to provide tax-saving strategies for them to consider. For the Rodgerers, as we do for all of our clients, we continue to discuss many possible strategies.
Each client situation has unique circumstances that will dictate both the appropriate strategies to generate tax savings and the actual financial impact. This example highlights the strategies that were appropriate for the Rodgerers, and it is a good illustration of different strategies we employ.
While we maintain a rigorous overall investment strategy including asset allocation and manager due diligence activities, we utilize after-tax strategies to further enhance value for our clients’ portfolios.
Learn more about Michael Chimento, CFA.
1 The after-tax return calculation is consistent with the industry’s accepted methodology which captures the full tax benefit on realized capital losses in the year they are generated.Read the PDF