Managing Capital-Gains Exposure: The Role of Tax Overlay Managers in Wealth Management
Financial advisors who are struggling to manage the capital-gains exposure across multiple client portfolios now have a solution at their fingertips. By hiring a “tax overlay manager,” advisors can ensure that their clients are not hit with unexpected tax bills due to short-term capital gains.
According to Erik Preus, the group head of investment solutions at Envestnet | PMC, short-term capital gains can incur a tax hit of up to 50% in states with the highest income duties. This can come as a negative surprise to clients whose investments have performed well. By giving discretion to an outside firm like Envestnet, advisors can save their clients money through loss-harvesting and rebalancing across unified managed accounts.
Envestnet’s tax overlay service typically costs around 10 basis points, but the savings far exceed this fee. Preus emphasized the importance of outsourcing to an overlay manager, especially for advisors with a large client base. By doing so, advisors can scale their practice while adding value to their clients.
Industry resources and research are increasingly focusing on tax planning for investment portfolios, which is separate from preparing tax returns and directly related to traditional wealth management services. Tax “leakage” from hits to investment portfolio returns amounts to $600 billion in missing potential yield each year, according to an estimate by wealth management firm Avantax.
Behavioral coaching, asset location, and spending and withdrawal strategy – all of which relate to taxes – are highlighted as the three largest areas of value in the latest Vanguard Advisor’s Alpha report. Tax-smart asset location alone could add up to 60 basis points for some investors, the report stated.
In a book by Bill Harris, the former CEO of Personal Capital, Intuit TurboTax, and PayPal, tax strategy is emphasized as the single most important driver of investment performance. Harris argues that tax strategy is often more important than investment strategy and can significantly reduce taxes on investments.
The tax overlay service is just one example of how wealth management firms are increasingly working in both tax and wealth management fields. This trend is seen through mergers, like the one that brought Preus to Envestnet from Placemark Investments in 2014, as well as through expanded capability launches.
Overall, incorporating a focus on the impact of taxes on after-tax performance is becoming an essential part of an advisor’s role and a compelling value proposition for clients. The growth in this area reflects a natural evolution in the industry over the last 20 years.