Tax Aware Investing

by | Nov 18, 2016

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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.

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Conventional Tax Alpha Tactics

by | Nov 18, 2016

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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.

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Tax Alpha in One Step

by | Nov 18, 2016

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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.

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AAVUL Tax Shield Primer

by | Nov 18, 2016

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Let’s see how double A VUL is put together by looking at a couple financial models. Here, a client is in the 35% blended federal and state tax bracket. Assuming a 6% annual return and 1.6% in total costs for the double A VUL policy, your client will earn more in tax savings than the policy’s costs in year six. Emphasizing once again that the tax savings compounds over time, the amount of increased wealth, the tax alpha benefit, increases each year.

At 10 years, your client has $15,000 more wealth than keeping the money in the taxable portfolio, and by year 20, this increases to over $70,000. When viewed as return, you’ve delivered an extra 7.22% in total return; this is the tax alpha benefit.

Do you see the star over the death benefit column at the far right? Double A VUL has a very important life insurance component and that is the death benefit. After breaking even on the tax savings alone, your client also has a highly valuable death benefit. Let’s go back to what a variable insurance product is. The word “variable” is associated with a payout structure that isn’t fixed but variable. For a death benefit, it grows as the variable portfolio grows.

With term and whole life insurance, the death benefit is fixed. What ends up happening over 10, 20, or 30 years is the purchasing power of the death benefit declines with inflation. This can have a severe impact in how your wealth transfer, wealth replacement, and estate plans are executed. Many advisors overlook the importance of paying more into premium to increase term and whole life death benefit amounts in order to keep the required inflation-adjusted value.

You don’t have this issue with Double A VUL. The Double A VUL death benefit increases with the underlying portfolio’s value. With your portfolio guidance and advice as you build, manage, and monitor the Double A VUL portfolio, you will expect a higher return than the insurance company’s fixed income portfolio that backs term and whole life death benefits. This means that double a VUL’s death benefit has built-in inflation protection and it always remains under your direct oversight.

This model keeps all other inputs the same, but increases the tax rate by 5% to a total federal and state blend of 40%. Remember, that each dollar saved in taxes creates wealth and increases the client’s ROI. At higher and higher blended tax rates, more dollars are reinvested into the portfolio and more compounding occurs.

At a higher blended tax rate, your client’s breakeven on all the double A VUL’s expenses is in the 4th year. At 10 years, this high-income client gains an extra $32,000 in wealth, and at 20 years you’ve increased your client’s wealth by over $125,000. Another way to look at double A VUL’s powerful economic benefits is to consider the added value you bring to the portfolio and to your client’s increased after-tax returns.

For example, assume you manage $5 million of this client’s wealth and you charge 75 basis points for doing so. That’s $37,500 a year. In year 11 of this model, the annual tax alpha benefit produced by your Double A VUL portfolio will exceed your overall AUM fee for all the client’s wealth. In other words, your tax alpha services produce more in savings than your entire AUM fee!

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