The recent $1.5 trillion tax reform has been heralded as everything from economically impotent to over-stimulating. But one thing reform certainly was not: sufficient. That’s because the 2,600 pages of U.S. tax rules remains a playground for experts to find savings for their clients that are nearly impossible for the bulk of non-experts to benefit from.
One favorite example of this is a tactic called tax-loss harvesting, made possible by Internal Revenue Code § 1091. In short, an investor can recognize a loss for tax purposes when they sell securities as long as they don’t purchase “substantially identical securities” within 30 days.
More sophisticated professional money managers will opportunistically scan for losses in their client portfolios to realize and immediately repurchase securities that behave with almost identical similarity, but are not considered “substantially identical” by the IRS. This tactic allows investors to reduce taxes today and defer gains into the future. Internal Revenue Code § 1014 goes one step further by adjusting the cost basis of securities to fair market value at death, eliminating gains all together.
While we’ve seen hyperbolic marketing about the efficacy of this tactic by some popular investment companies, a realistic estimate of the value for tax-loss harvesting is an extra 0.10 percent in annual gains. Not much, but every dollar counts when you are hired to manage wealth.
One favorite example of this is a tactic called tax-loss harvesting, made possible by Internal Revenue Code § 1091. In short, an investor can recognize a loss for tax purposes when they sell securities as long as they don't purchase "substantially identical securities" within 30 days.
Another tax-reducing tactic is the strategic placement of assets across different financial accounts, known as asset location. Since each asset class, from emerging stocks to U.S. bonds, has a unique expected growth rate and tax profile, you can create algorithms to determine the ideal financial account type for different investments. Simulating every combination of asset placement across account types can produce meaningful wealth gains for clients by reducing lifelong taxes and increasing after-tax returns.
Utilizing the multitude of retirement account types provides yet another opportunity to reduce taxes. Navigating the subtleties between IRAs, 401Ks, HSAs, 529s and every other nuanced savings vehicle is difficult for professional financial advisors, let alone typical households in our experience. Here, too, though, you can use technology-driven algorithms to determine the financially optimal account to open, contribute to and withdraw from, which can reduce taxes and increase wealth.
Probably the most sophisticated tax tactic, though is to utilize one of 40 different trust types made possible by Internal Revenue Code §§ 641 to 692 — something only about 2 percent of U.S. households currently use, and a vehicle we see few investment managers able or willing to do. Tax savings can be quite large, particularly when transferring assets. Certain specialized trusts can even help households qualify for Medicaid eligibility in the unfortunate event that long-term care is needed.
Fiduciaries are legally responsible to pursue the best interest of our clients, which motivates us to utilize every page of the tax code for potential wealth benefits. But a better tax system wouldn’t require that expertise in the first place. The time and energy we invested in the technology and methodology to digitize the U.S. tax code would be better utilized helping clients in more meaningful ways.
Probably the most sophisticated tax tactic, though is to utilize one of 40 different trust types made possible by Internal Revenue Code §§ 641 to 692 - something only about 2 percent of U.S. households currently use.
In addition, while tax expertise can provide a competitive advantage over other firms, it should not provide an advantage over other taxpayers that do not have access to the sophisticated technology needed to optimize decisions about obscure tax rules. It also erodes the efficacy of tax policy if it requires esoteric algorithms that few can access.
Other developed nations, such as Australia and New Zealand, have addressed these types of tax inefficiencies. In 1987, for instance, Australia introduced “franking credits” to eliminate the double taxation on dividends. New Zealand introduced a similar system shortly thereafter and currently has no capital gains tax.
More fundamentally, a meaningful bipartisan effort to break bread over the founding principles of the modern individual tax code strikes us as long overdue.
With roots in the 16th Constitutional Amendment passed over 100 years ago, our forefathers very simply increased taxes as income grew. That basic public policy didn’t require specialized expertise to understand. More importantly, it set this country on a path to become a great economic, military, and moral global leader in the 20th century. It’s time to continue that tradition in the 21st century.
The more complex society we live in today may very well require a more sophisticated tax code than the original. However, it seems well worth the effort to start at the same page we began with 100 years ago and work from there.