Advisors and Clients Value Tax Deferral, But Unaware of Full Scope of Benefits

Laurence P. Greenberg for WealthManagement.com writes:  High tax rates are top of mind for every advisor as they see the impact on their clients’ returns, and therefore this issue is increasingly becoming important for clients as well, particularly for those with higher incomes. As a result, tax management has become critical. High net worth investors face not only the impact of prolonged periods of increased tax rates on their investment performance, but also a challenging market environment in which to generate wealth. Not surprisingly, according to Jefferson National's recent survey of financial advisors, the vast majority (91 percent) of advisors use tax-efficient investing strategies to mitigate tax burdens for clients.

Tax deferral is central to creating tax efficiency.  Jefferson National’s survey found that 96 percent of advisors state that tax deferral is important in the current environment and 86 percent of advisors expect that tax deferral will be even more important in the future. Following the same trend, 59 percent of advisors have increased their use of tax deferral over the past five years.

Further Education Needed Around Tax Deferral Benefits

Even though tax deferral is viewed as an essential tool to maximize wealth and generate more retirement income, Jefferson National's survey revealed a lack of understanding around the scope of benefits associated with tax deferral—for both advisors and their clients. Only 19 percent of advisors are aware that low-cost tax deferral can add up to 100 bps of alpha to an investment portfolio without increasing risk, and 59 percent say their clients have no knowledge about tax deferral beyond traditional 401(k)s and IRAs. This ultimately means that many investors are leaving opportunities on the table to maximize their wealth through other tax-deferred vehicles, such as a new generation of low-cost, investment-only variable annuities. Advisors can provide more value for clients by educating them on the accumulation benefits of leveraging a low cost, investment-only tax-deferred account in a retirement income plan once traditional 401(k)s and IRAs have been maximized.

How to Leverage Tax Deferral Through Asset Location

As advisors depend more on tax deferral to maximize accumulation, defer current taxes and prepare for their client’s future lower tax brackets, they must look for the right type of tax-efficient investing strategies to create "tax alpha" without increasing risk. Of the advisors who use tax-efficient investing strategies to mitigate taxes, almost all (92 percent) use asset location in a tax-deferred vehicle to help their clients. Advisors can leverage low-cost tax deferral and boost accumulation by using asset location to help minimize the impact of taxes and enhance after-tax returns. To start, advisors should not only evaluate their clients' portfolios by asset class or risk, but also by tax characteristics: tax-efficient assets vs. tax-inefficient assets.

Advisors can further evaluate tax efficiency by looking at their clients' breakeven points, which is the point in time when tax deferral will help assets yield a better after-tax return. Tax-inefficient assets, such as bonds and REITs that can have breakeven points of one year or less, should always be located in a low-cost, investment-only tax-deferred account. By locating fixed income assets in these accounts, advisors can potentially improve returns by as much as 100 bps without increasing risk, according to a concept known as the "Tax-Efficient Frontier."

Expanding Tax Deferral Vehicles

After advisors examine the breakeven points, they need to locate tax-inefficient assets and strategies in traditional tax-deferred vehicles, such as IRAs, 401(k)s first and then leverage next-generation low-cost, investment-only tax-deferred accounts once the traditional vehicles have been maximized. This will help minimize taxes on accumulation and maximize after-tax returns. These tax-deferred accounts allow the returns from tax-inefficient assets to compound without a tax penalty until income is distributed. This approach is attractive for any client preparing for retirement.

Tax deferral should be a key component to any advisor's retirement planning process with a client. Given the impact of taxes on investor returns, a systematic usage of tax-efficient investing combined with broadening tax-deferred accounts is becoming a critical part of advisors' strategy to help improve retirement income for their clients.  

Laurence P. Greenberg is President of Jefferson National.