As CPAs and investment advisors partner to map out a strategy for clients, the delicate balance between tax effectiveness and control over assets should serve as a centerpiece. This will help to create a strategy that maximizes investments, minimizes tax exposure, and helps maintain clients' long-term financial objectives.
There are a few simple issues that may catalyze portfolio re-allocation and therefore present an opportunity to recalibrate and achieve that desired balance. For example, current preferential tax rates on qualified dividends and capital gains will expire in 2011 unless Congress decides to extend these provisions. This may have a significant effect on investment strategy in 2010, including a wave of liquidations of "in the money" long positions.
If clients choose to go this route, it will be important for them to carefully consider tax and transparency as they allocate investments. Families with a new pool of liquidity have been trending towards adoption of an endowment model, which is highly effective for foundations and employs a structure of "managers of managers." But the system is based on a model that has been designed for non-taxable entities and exposes investors to consistent movement between asset classes - shifts that create tax events. For individual investors, while performance numbers can look exciting in marketing materials, tax returns can look very different. In the rush to follow the money, then, families are creating additional tax exposure and losing transparency to an ill-suited model.
Placing too much cash in insurance can be equally risky. Life insurance is an excellent vehicle and may help avoid estate tax, remove tax liabilities, and provide post-mortem proceeds; however, the lack of portfolio transparency can send investors down a crippling path. Funds might be backed by an insurance company, but policyholders pay significant after-tax funds to invest in a portfolio with limited clarity. In short, investors are at the mercy of their insurers for sound money management.
On the other hand, charitable remainder trusts provide tax benefits, diversification opportunities, and the desired control over assets. CRTs are an arrangement by which a donor creates a trust that is generally funded with low-tax-basis stock, which is often immediately sold and re-invested in a diversified pool of investments. The donor gets a current income tax deduction for the present value of the future interest, which will eventually pass to a qualified charitable organization. The trust does not pay a current capital gains tax when the low-basis investments are sold, but it does pay an income stream back to the donor for an established term, for the life of the donor, or even for multiple generations if beneficiaries are designated.
A grantor retained annuity trust is another investment vehicle that acts in a fashion similar to an annuity, as the trust is created for a designated period of time and makes payments on a fixed annual basis. The grantor receives total periodic payments equal to the original trust principal plus interest based on the federal mid-term rate. If the underlying GRAT assets appreciate more than the federal mid-term rate, the excess goes to the trust beneficiaries without incurring a gift tax. This can be an excellent tool to pass highly volatile investments to your family without incurring a gift tax.
Investors can also rebalance by putting tax-efficient investments in regular brokerage (nonqualified) accounts and tax-inefficient investments in qualified accounts (IRAs, 401(k)s). This allows for a greater measure of control over investment selection, as investors can pick their account managers for non-qualified plans. Even for qualified retirement plans, managers will often provide guidance.
Tax-efficient investments such as equities generally have a maximum tax rate of 15 percent on income, including qualifying dividends and capital gains, and some taxpayers will qualify for significantly lower federal tax rates under current tax law. One of the most striking inequities in the current Tax Code is the taxation of qualified dividends and capital gains at ordinary income tax rates when withdrawn from a qualified retirement account. This can have a sizable impact over the course of a few decades; a common misstep of long-term investing is holding tax-favored investments in retirement accounts when the returns could be growing more favorably in other vehicles. On the other hand, tax-inefficient investments such as corporate or taxable government bonds might be better suited for a qualified retirement account. Income from these vehicles is taxed at the highest marginal rates, but those taxes are deferred until retirement.
In the end, these waters can be most effectively navigated when anchored by a sound partnership between advisors and CPAs. Both sides of the equation can provide greater stability and long-term results by employing a philosophy that mitigates short-term financial risk while emphasizing stewardship, due diligence and control over assets.
Chat Reynders is chairman of Boston-based investment firm Reynders McVeigh Capital Management. Michael Lynch, CPA, is a principal at Tyler Lynch in Cambridge, Mass., and specializes in tax planning for high-net-worth individuals.
