One of the founding principles of my firm has always been that effective financial advice must address all issues facing a client together, rather than in isolation. So for us, wealth management has always included a tax-planning element.
If a certain provision of the Senate’s tax bill makes it into law, the way we manage nearly $1.4 billion on our clients’ behalf will abruptly change.
Nothing in the Republicans’ tax plan would fundamentally alter our approach of broadly diversifying and regularly rebalancing our clients’ portfolios. But if adopted, this particular provision would change how we go about these tasks and, to the extent we can’t work around the new law, it would cost our clients more money sooner in taxes (which is exactly what the drafters intend).
Many investors hold multiple lots of the same security, purchased at different times and at different prices. Under the current rules, investors selling only part of their position are allowed to choose which shares they will sell. Assuming investors hold these shares in a taxable account, this flexibility is important, because it allows investors to adjust their holding while minimizing taxable capital gains, or even realizing a capital loss to offset other gains in a particular tax year.
The Senate tax bill would end this practice. Instead, investors selling a partial stake would have to dispose of their shares on a “first-in, first-out” basis, selling the oldest shares first regardless of their original cost.
This provision is not included in the House of Representatives’ tax proposal, and many House Republicans have urged their colleagues to drop it. But the rule’s supporters argue that it could raise as much as $2.4 billion over the coming decade. Presumably they had originally hoped for even more, but in November the Senate Finance Committee exempted mutual fund firms from the new rule because industry advocates effectively argued that it would damage market efficiency. So now it is only individual investors facing this unwelcome change.
At Palisades Hudson, we work with our clients by establishing their overall tolerance for risk, in the form of short-term volatility, and their long-term growth objectives. Together, these let us know what portion of their portfolio can safely be put in equities without undue risk that they will feel forced to sell during market downturns and miss the ensuing recovery.
One way we reduce volatility – and thus increase the amount our clients can hold in stocks, which improves long-term performance – is by diversifying among asset classes, including large- and small-cap U.S. stocks, international stocks and stocks focusing on particular asset types that function as hedges against inflation, such as real estate and natural resources. Often one class performs notably better or worse than most of the others for a period of time, so the portfolio moves away from our targets; we rebalance the portfolio to get back to where we want to be. And we carefully choose both the securities we sell and the particular purchase lots of those securities to minimize taxes.
For us, the main short-term effect of the Senate provision might arrive in the closing days of December if the bill passes with an effective date in 2018. We might hurry to sell high-cost shares of some securities to raise cash, rather than waiting until January, when the new law would force us to sell the oldest (and often, though not always, the lowest-cost lots) to raise equivalent amounts, thus triggering larger tax bills for our clients. If we have clients who plan to make gifts of appreciated securities to charitable organizations, we may also encourage them to make such gifts before the end of the year to maximize their value.
When we reinvest the cash generated by such sales – and when we invest future portfolio additions or sales proceeds for our clients – we will tend not to do it in securities or mutual funds we already hold, because of the new, adverse tax rules. Instead, we will find similar investments that we don’t already hold for that client. Then we will buy the alternative investment, giving us the option to sell higher-cost Security B rather than lower-cost Security A when we want to rebalance or raise cash for other purposes.
With this strategy, we will end up identifying and holding a larger number of mutual funds and other investments for our clients overall, but we won’t run out of options – there are far more available than we will need to consider. Such investments might not necessarily be our first choices on a pretax basis, but the tax wrinkle will lead us to add funds we might not otherwise use to give ourselves more flexibility to optimize taxes for our clients.
We will also do more of our rebalancing in clients’ IRAs and other tax-sheltered accounts, where the new rule won’t usually matter at all.
The net result will be that clients of tax-aware managers, like us, will hold smaller amounts in larger numbers of funds. This will drive up administrative costs for fund managers (and ultimately for investors), though probably to a small degree since mutual fund recordkeeping is highly automated. Some investors may split up positions among multiple brokerage accounts to work around the new rule. If it passes, I don’t think the new rule will end up generating as much revenue as its authors expect, because tax-aware investors (or, more often, their investment advisors) will adjust their behavior to compensate. Whatever added revenue that the first-in, first-out rule does generate will mainly come from the smallest and least-sophisticated group of investors, who lack the time, skill and portfolio accounting software to do for themselves what we will be doing for our clients.
In the end, the new rule might be good for the business of investment managers like us, since it will encourage investors to vet, monitor, hold and track a wider range of securities. But that’s not the way most of us want to build our business, which is why the industry has vociferously opposed the plan.
The Senate rule might not survive a conference committee. If it does, investors should be ready to move quickly in the last days of December, and to change their strategy going forward so they don’t end up paying taxes on a first-in and often worst-out basis.