Our focus here is on the degrading impact taxes have on wealth, because taxes occur every year. The top 1% of earners make $450,000 and at this level the marginal federal rate is almost 40%. If you include the Medicare surtax, the top marginal rate is over 43%.

For clients in high-tax states, a marginal rate over 50% is a fact of life. Portfolio taxes, whether from portfolio income or realizing gains, is considered marginal income since it is not earned. This means that the blended federal and state income tax is claimed first against earned income, which is closely monitored by the IRS.

So, you have a dilemma. Your clients are anxious about market volatility so you structure the portfolio to keep it resilient in the face of a market decline. However, many of the investments used to moderate volatility, investments such as fixed income, alternative investments, REITs, and dividends from non-US stocks , are subject to income tax rates each and every year.

Nor can you lose sight of the negative impact that capital gains taxes have on your clients’ wealth creation. Although the top federal capital gains tax rate is 20%, all states also charge taxes on capital gains. The average capital gains tax rate for all states is over 28% with California residents paying 33% and nine states with the lowest at 25%.

But, here’s the tax impact kicker. Rates of return on stocks of all types historically are much higher than fixed income. So, while the tax rates may be lower than marginal income tax rates and gains are realized only every few years, the reinvestment of the tax savings is higher. For this reason, you will often see the benefits of tax alpha highest for equity investments.

To sum up the Advisor’s Dilemma, you trade one leakage, market declines, for another, taxes.

But, clients actually put you in this dilemma! While market anxiety is at a high level, the majority of high net worth clients according to the US Trust study set this standard, and I quote: “, “it’s more important to minimize the impact of taxes when making investment decisions than it is to pursue the highest possible returns regardless of the tax consequences”

Being responsive to this sentiment, 81% of advisors, according to the quarterly Russell Financial Professional Outlook, are concerned about producing higher after-tax returns for clients.

The column on the left highlights the various tax alpha tactics at your disposal. Each tactic, though, comes with a requirement. We can translate the word “requirement” into planning time, execution time, and labor costs.
You see, producing tax alpha with these tactics is customized to each client. Since competition prevents you from raising prices, time and labor costs means that your per client profits decrease when executing tax alpha services. While we’ve seen that increasing after-tax returns is of high demand among clients, advisors find it increasingly challenging to deliver these services.

Let me note one tax alpha tactic that isn’t often specialized: municipal bond investing. For tax-aware advisors looking to produce tax alpha, some would consider municipal bonds as a staple for high-income clients, particularly muni bonds that are based on the clients’ state of residence.

There are a couple key points about muni bond investing and their taxable structure. First, if muni bonds increase in price and are sold with a gain, capital gains tax rates apply. Second, private activity bonds such as those issued to fund stadiums, hospitals, and public housing are subject to the alternative minimum tax.

If you invest in specific muni bonds, then the capital gains and AMT are under your direct control, but this does increase your service costs in managing customized portfolios. However, when investing in a muni bond mutual fund, be aware that what is presumed to be tax free may, in fact, not be 100% the case.

Advisor-applied VUL, or Double A VUL, solves the advisor’s dilemma. First, Double A VUL is fully tax free. Tax-free income. Tax-free growth. Tax-free death benefit. No alternative minimum taxes. And, especially important for wealth planning, tax-free cash access.

Let’s be clear this is not “tax deferred” as is the case with retirement accounts, variable annuities, or education-funding plans. This is tax free, just like an institutional investor enjoys.

This means that any investment gains full tax-free status. Interest payments. High turnover strategies. Dividends from non-US stocks. REIT income. Here are a couple points about tax-free investing beyond the obvious importance of putting these tax inefficient investments in the Double A VUL portfolio.

Every tax dollar saved is compounded back into the portfolio. For this reason, high-growth equities greatly benefit from being in Double A VUL because, even though the capital gains rates are lower than income tax rates, reinvesting the taxes when they are realized at higher rates of return generates substantial extra dollars compared to keeping these equities in a taxable account.

And, let’s revisit the point about muni bonds. With Double A VUL, any investment gets the same tax-free treatment of a muni bond . . . and more. There are no capital gains taxes and no alternative minimum taxes. This allows you to move past the low-yield muni bond offerings, along with worries about default risk, into investments with a much more attractive return profile that you manage in a fully tax-free structure.

Putting this all together, Double A VUL is a tax alpha program in one single step. Wealth is preserved by saving on portfolio taxes and, at the same time, wealth is created because the tax savings compounds.