I have increasingly witnessed registered investment adviser (RIA) firms, as well as brokerage firms, generally disavow (often in their client services agreement) any duty to manage the investment portfolios of their clients tax-efficiently, often through a blanket statement that “tax advice is not provided.”
This post seeks to ask, and generally answer, two questions: First, do brokers and investment advisers possess a duty to design and manage investment portfolios tax efficiently? Second, is tax-efficient portfolio management scalable within the large investment firm today?
The RIA’s Fiduciary Duty of Due Care – and Taxes
The triad of fiduciary duties, under state common law, are said to include the duty of due (professional) care, loyalty, and utmost good faith. Does the duty of due care include a duty to design and manage a portfolio tax efficiently?
While the tax law is full of complexity, one can easily include that an RIA and its investment adviser representatives (IARs) possess a duty of due care with respect to minimizing the long-term tax impact of investment decisions, considering all the circumstances at the time. While the tax law is complex, and not every tax issue faced by a client is subject to an investment adviser’s duty of due care, it must be noted that IARs in the Series 65 exam are tested on the tax implications of fixed income securities and pooled investment funds. In addition, the test covers income tax fundamentals relating to an individual (“e.g., capital gains; qualified dividends, tax basis; marginal bracket; alternative minimum tax”), as well as income tax fundamentals for trusts, estates, and corporations. The scope of the Series 65 exam implies that every investment adviser should possess foundational knowledge on tax-efficient investing – and should apply that knowledge when serving their clients.
The RIA’s / IAR’s fiduciary duty of care is not easily waived, nor disclaimed, as the legal concepts of waiver and estoppel possess limited application to the fiduciary-client relationship.
Reg BI and a Broker’s Duty of Care Regarding Taxes
Similarly, the Series 7 exam topics include several areas regarding taxes, including knowledge of the taxation of retirement plan accounts at retirement, the tax treatment of equity transactions, the tax treatment of mutual funds, variable annuities, REITs, various types of fixed income securities, 529 accounts, and other investment products.
However, prior to Regulation Best Interest (“Reg BI”) brokers and registered representatives did not possess a fiduciary-like duty (except in certain instances, such as when a relationship of trust and confidence was formed, de jure or de facto discretion was exercised over an account, or the broker became a “fiduciary” as defined by ERISA). Nor did brokers, prior to Reg BI, possess a duty to act in the “best interest” of a customer. Hence, it is likely that any obligation to consider taxes when selling investments, under pre-Reg BI authority, did not generally exist. (However, tax considerations were required to be considered for variable annuity sales, under FINRA rules.)
Regulation Best Interest, promulgated in 2019, now imposes upon brokers (BDs), among other duties, a general obligation of care. From this general obligation of care likely flows a duty to design and manage investment portfolios tax-efficiently.
On April 20, 2023, the SEC issued its “Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Care Obligations” states, in pertinent part: “In the context of providing investment advice and recommendations to retail investors, the care obligations generally include three overarching and intersecting components. As discussed in more detail in the following questions and answers, these components are … Having a reasonable understanding of the specific retail investor’s investment profile, which generally includes the retail investor’s financial situation (including current income) and needs; investments; assets and debts; marital status; tax status; age; investment time horizon; liquidity needs; risk tolerance; investment experience; investment objectives and financial goals; and any other information the retail investor may disclose in connection with the recommendation or advice ….”
Further, when recommending an investment product or strategy, the Staff Bulletin stated that “when determining whether an investment or investment strategy is in the investor’s best interest, in the staff’s view, the firm and financial professional should consider, where relevant, the following non-exhaustive list of potential costs … any relevant tax considerations; and the likely impacts of those costs over the retail investor’s expected time horizon.”
In a subsequent section of the Staff Bulletin, the SEC Staff opined: “[T]ax status is part of the retail investor’s investment profile. What does it mean to consider the investor’s tax status when providing recommendations or advice? … There are many investments and investment strategies where a primary feature may be a tax advantage for the investor (e.g., 529 plans, tax loss harvesting, opportunity zone funds, donor-advised funds, direct and custom indexing, variable annuities, government securities, 401(k) accounts, and IRAs). Where a retail investor or a financial professional identifies a goal with tax implications (e.g., including, but not limited to, saving for retirement or a child’s education) or seeks to obtain a particular tax advantage (e.g., tax loss harvesting or limiting capital gains) as an investment objective, the staff believes that a firm and its financial professionals should consider whether the tax-advantaged option covered by their recommendation or advice is in the best interest of the retail investor based on the retail investor’s investment profile … An investor’s or account’s tax status may also be an important consideration when selecting or providing advice on a particular investment or investment strategy relative to other options – such as whether a fixed income investment pays taxable, tax-free, or deferred interest, whether an out of state 529 plan is in the best interest of a customer who lives in a state that offers tax benefits for investing in the home state’s plan, or whether a buy-and-hold or more frequent trading strategy is best for a particular account.”
In essence, SEC Staff has stated that brokers (and their registered representatives) possess a duty of care, which includes the consideration of taxes when providing investment advice. The SEC Staff views the “tax drag” on investment returns as similar to the “fees and costs drag” on investment returns.
Moreover, this duty to consider taxes when designing and managing investment portfolios appears to be a non-waivable duty for BDs, for as stated in the 2019 adopting release for Reg BI, “under Section 29(a) of the Exchange Act, a broker-dealer will not be able to waive compliance with Regulation Best Interest, nor can a retail customer agree to waive her protections under Regulation Best Interest.”
Minimizing Tax Drag is Important
If there is any doubt regarding a general obligation to consider the tax impact on a client of various investment recommendations, one should consider the importance to many individual clients of tax-efficient investing strategies and portfolio management. According to an SEC study, investors in actively managed mutual funds lost an estimated 2.5% a year in annual returns to taxes. Another study by the accounting firm KPMG Peat Marwick for the Congressional Joint Economic Committee found that the annual impact of taxes ranged from zero for the most tax-efficient funds to 5.6 percentage points for the least. Combined with actively managed stock mutual fund costs (both “disclosed” and “hidden”) that averaged 2.8% or more per year (at the time of the study), taxes and costs combined to eliminate 50% or more of an investor’s expected annual return. On a compounded basis, that 50% loss equated to an erosion of the vast majority of the returns the capital markets had to offer to individual investors.
Other industry and academic research extoll the benefits of the consideration of taxes when advising individual investors. As stated in the SEC’s 2019 release of Reg BI, “academic studies document a multitude of other benefits that accrue to retail investors as a result of seeking investment advice, including, but not limited to: Higher household savings rates, setting long- term goals and calculating retirement needs, more efficient portfolio diversification and asset allocation, increased confidence and peace of mind, improvement in financial situations, and improved tax efficiency.”
In a December 5, 2022 article, “Why Advisors Should Bother With Tax Alpha,” Sheryl Rowling of Morningstar opined: “How can advisors truly add to investment performance without adding risk? By creating ‘tax alpha.’ An advisor can generate tax alpha by incorporating tax-savings strategies into investment management that provide clients both permanent and temporary tax savings. As we’ll see, both can be very valuable to clients.” Sheryl Rowling then went on to summarize several tax-saving strategies advisers can utilize.
Beyond portfolio design and management strategies, a plethora of tax planning opportunities exist for many clients, such as the use of tax-deferred (qualified and non-qualified) accounts, Roth IRA funding or conversion planning, the use of 529 college savings accounts, the funding of Health Savings Accounts, tax-free exchanges in several different contexts, and many, many more. Brokers and investment advisers who provide (or claim to provide) “financial planning” or “comprehensive financial advice,” or similar terms, likely possess a duty of care to their clients to examine opportunities for tax savings through various financial planning strategies. Always applicable to every form of commercial or fiduciary relationship is the old adage, “Say what you do; do what you say.”
Ways to Meet the Duty of Care with Respect to Tax Planning
An investment adviser or broker who initially lacks the skill or knowledge required to meet the needs of a particular client, including the need to design and manage a portfolio tax-efficiently, may overcome that lack through additional research and study. Numerous educational opportunities exist to acquire this knowledge, from readings, to conference sessions, to Certified Financial Planner(tm) certification or Chartered Financial Analyst certification, to podcasts, blogs, and vlogs.
The needs of the client may also be met by involving another financial advisor (within the same firm, or outside the advisor’s firm) or other professional who possesses the requisite degree of skill or knowledge. For example, a client with low-basis concentrated equity positions may well be served by either various option strategies, an exchange fund, or other tax strategies that may be beyond the ability of many financial advisors to implement; in such instance additional expertise should be brought to bear.
The general obligation to consider tax consequences should not be avoided by the financial adviser merely stating, in a client services agreement or investment policy statement: “Client acknowledges that Adviser does not render tax advice.” Nor would a statement such as “It is Client’s responsibility to consult with his or her own legal and tax counsel where such consultation is deemed necessary” absolve the investment adviser or broker from the obligation to consider taxes when designing and managing investment portfolios. As stated above, blanket waivers or disclaimers of fiduciary duties are likely ineffective for RIAs. And, as stated previously, for brokers, the duties imposed by Reg BI, including its duty of care, are not waivable.
Principles This Author Follows for Tax-Efficient Portfolio Design and Management
My first principle is that tax-efficient portfolios should be designed around the types of accounts the client possesses. Many clients have qualified (traditional IRA) accounts, Roth IRA accounts, and taxable accounts. For example, as a general rule asset allocation among various forms of accounts might be implemented, tax-efficiently, with the following guidelines:
First, allocation foreign stocks to taxable accounts. Since mutual funds owning foreign stocks pay taxes on stock returns to foreign countries, under tax treaties between the U.S. and many other countries, seek to avoid a “double taxation” of investment returns by securing tax credits (or deductions) for foreign taxes paid by the U.S. resident or U.S. citizen investor.
Second, place the remaining asset class(es) with the highest expected returns in the Roth IRA account. Obtain the most benefits from the tax-free nature of Roth accounts.
Third, place fixed income assets in the account that has tax-deferral, but when withdrawn tax on all gains in the account are taxed as ordinary income. In other words, place fixed income assets in traditional IRA accounts, traditional 401(k) or 403(b) or 457 or other employer-sponsored retirement accounts. Consider whether to also utilize non-qualified tax-deferred accounts, considering the risks, fees and costs that might accrue.
Fourth, allocate REITs to taxable accounts, generally. It can be argued that any allocation to REITs belongs to taxable accounts. Generally, 20% of the ordinary income of REITs can be excluded under current tax law. However, REITs generate mostly ordinary income from their distributions; capital gain distributions are usually quite small, as a percentage of distributions, unless the REIT is winding up and going through the process of termination. Stated differently, individual REIT shareholders can deduct 20% of the taxable REIT dividend income they receive (but not for dividends that qualify for the capital gains rates). In some circumstances, however, REITs may be more appropriately allocated to tax-deferred accounts.
Fifth, allocate tax-efficient stock mutual funds (or, preferably, stock ETFs) to taxable accounts. Seek low-portfolio turnover stock ETFs for this purpose. The lower the portfolio turnover rate (if properly measured, not as typically reported using the SEC’s methodology), generally the lower the incurrence of capital gains within the fund (or ETF) from sales of equities within the fund.
Sixth, fill up the remaining allocations to the accounts, as needed. In actuality often the portfolio manager will only reach the third step, or fourth step, until all of the accounts are “filled up.” This is especially true when large 401(k)s exist, relative to the size of taxable accounts. (In fact, it is not unusual to see retiring mid-level executives with $2m, $3m, $4m, etc. – all in traditional 401k accounts and/or ESOP accounts.)
There are many potential exceptions to the rules above. For example, a client may already possess investment assets in taxable accounts with significant unrealized capital gains. The allocation of portions of an asset class between taxable and tax-deferred (or Roth) accounts may permit tax-free rebalancing, at least for some period of time.
And there are many concurrent portfolio management strategies that can be employed, such as harvesting capital losses, avoiding short-term capital gains by delaying portfolio rebalancing (or other sales), proper stock option exercise planning, and many more.
A second principle I observe is to manage the “held-away” accounts of individual clients. Such as for the client who is still working, who still has a 401(k) account with her/his existing employer. Or when existing investment options in a 401(k) account are better (or as good as) those found in a rollover IRA account. (A common example of this is the presence of a good stable value fund during a rising interest rate environment.)
In essence, with outside accounts advised upon, it is possible to construct a more tax-efficient portfolio. Yet, due to the time needed to analyze such held-away accounts and their investment options, then integrate the holdings with those in other accounts of the investor, far too many investment firms serving retail investors eschew this opportunity to add value.
Portfolio management software can import data from most held-away accounts. But, when doing so, sometimes additional costs (per outside account) are incurred. Also, performance reporting numbers may become suspect if the data downloads are not sufficient from the outside accounts to reflect all of the transactions that occurred in the account.
Again, the downside of not managing held-away accounts is the lack of ease with respect to scalability. The individual advisor should review, initially and each year thereafter (typically in January), the line-up of funds in the 401(k), 403(b), 457 or other account. If a client has non-qualified deferred compensation accounts, ESOP accounts, cash value life insurance, non-qualified annuities, etc., a similar analysis can occur. All of this analysis and work is time-intensive.
My third principle is that comprehensive financial planning should be delivered to most individual clients. As alluded to previously, there is much potential for tax savings during the financial planning process. Done correctly, it should be realized that personal financial planning is difficult to scale, although some efficiencies can be gained through the use of a team approach to developing and revising financial plans, the use of collaborative (with the client) financial planning software, efficient data gathering software, etc.
In Conclusion. There exist many opinions on the optimal manner to minimize the tax drag on investment returns. For example, some academics suggest all investments should reside in tax-deferred accounts. Other academics and advisers, such as myself, seek to leverage the different tax attributes of various types of accounts to boost the long-term after-tax returns of their clients, realizing that future tax policy changes are often unpredictable.
Each client’s situation is also somewhat different, which implies customized portfolio design, implementation, and portfolio management.
While various software can substantially aid in tax-efficient portfolio management, and in identifying tax-saving opportunities through financial planning, over-reliance on such software solutions should be avoided. While software solutions can often identify tax planning opportunities, it can also miss out on tax-saving ideas that fall outside the software’s existing algorithms. In the end, every financial advisor to individual clients should obtain and maintain a comprehensive knowledge of individual, trust, and estate income taxation.
I have observed many investment firms seek to disclaim any responsibility for the provision of tax advice to their portfolio management and/or financial planning clients. I doubt such disclaimers, when broad-based, are legally effective. Simply put, the duty of care possessed by both RIAs and BDs requires the application of tax knowledge in the design and management of the investment portfolios of most individual investors.
I have also observed many, many individual investors who possess a tax-inefficient placement of asset classes in their overall investment portfolios. And even more investors possess tax-inefficient equity mutual funds in their taxable accounts when tax-efficient ETFs and other investment vehicles are readily available.
The duty of care to the client found within an investment adviser’s fiduciary duties – and found within the registered representative’s duty to adhere to a customer’s best interests – requires the application of a high degree of expertise. To the extent that some financial advisors do not possess the requisite knowledge to spot tax saving opportunities, and to the extent that RIAs and brokerage firms do not tax-efficiently manage their clients’ and customers’ investment portfolio, the need exists to change these practice methodologies and behaviors.
For many firms, this may also involve considering (and receiving compensation for) the management of held-away accounts, as a means of more optimally adhering to the duty of due care – and adding value to the individual investor. The lack of scalability in providing such services should be considered when establishing reasonable levels of compensation.
The duty of care, whether found under the fiduciary standard applicable to investment advisers, or under Regulation Best Interest for brokers, should not be ignored. It is time for many investment firms to raise the bar and to properly adhere to their obligations.