Tax-Proofing Client Portfolios for a Changing Political Climate

While it is too early to call the election, it is never too early to make proactive portfolio enhancements to improve your clients’ tax situation.

September 18, 2008
Sponsored by Rochdale Investment Management

by Garrett D'Alessandro, CFA, AIF®, Chief Executive Officer and President, Rochdale Investment Management

Anticipated changes in tax rates are an excellent opportunity for CPAs and advisors to demonstrate a proactive strategy for clients. In this article we examine a framework for assessing the potential impact of anticipated changes in capital gains and dividend tax rates, to help your clients get ahead of the changes, regardless of who wins the election.

There are three main phases to arriving at a successful plan:

  1. Assess the existing portfolio for tax effectiveness under new anticipated tax rates.

  2. Prepare a scenario analysis of changes to the existing portfolio and arrive at the expected tax impact.

  3. Prepare new portfolio characteristics and assess future after-tax cash flows and returns.

While the actual new tax rates cannot be known with certainty, a scenario-based approach enables an assessment of the likely outcomes. The value of the process arises from the ability of the CPA/advisor to be ready well enough in advance to have specific action steps prepared as greater clarity emerges on the likelihood and degree of tax rate changes. For example, if the chances were very high that capital gains tax rates would go up, but it was not known by how much, it still would be appropriate to consider the disposition of selected stocks from the portfolio in order to realize higher after-tax gains.

Step 1: Assess the existing portfolio for tax effectiveness under new anticipated tax rates.

To assess how efficient and effective the portfolio will be under new tax rates, CPAs and advisors can look at the current portfolio on several dimensions:

  • What is the potential impact to portfolio cash flows after new taxes?
  • How favorable or unfavorable is each asset class under the new tax rates?
  • What unrealized capital gains are embedded in the existing portfolio?
  • What is the sensitivity of the total returns to changes in tax rates?

For many clients, their portfolio represents a source of cash flows to meet their living commitments and obligations. Each aspect of the portfolio cash flows should be measured before and after the prospective tax changes to arrive at potential increases or decreases in cash flows. Additionally, each component of a client's asset allocation can be graded along a continuum of highly favorable to least desirable under the new tax rates. Then drill down on an individual holding basis to arrive at the amount of capital gains due were a stock to be sold. Finally, consider each manager's trading strategy. For example, a portfolio manager employing a long-term investing approach will be impacted by a capital gains tax rate increase more than will a manager with a short-term trading strategy. Being able to manage the amount of gains realized also influences the impact that new tax rates can have on a portfolio. The ability to control the level of realized gains is usually possible only when working with investment managers offering highly personalized service; it is virtually impossible in a best-of-breed wrap manager structure.

Step 2: Prepare a scenario analysis of changes to the existing portfolio and arrive at the expected tax impact.

The second phase includes performing scenario analysis on what the likely tax rates will be in the future for each asset holding and the portfolio's overall cash flows.

During this phase, it is useful to prepare a spreadsheet that shows the before- and after-tax cash flows expected from each portfolio holding before and after the proposed change. If you are not sure what the final tax rates will be, this scenario analysis will be the method for you to judge the impact each proposed tax rate change might have on each holding within the portfolio. If, for example, the expectation is that tax rates on capital gains and dividends are expected to rise, but the actual amount of increase is uncertain, then using the range of possible tax increases gives perspective on how much less the portfolio would generate under higher capital gains and dividend taxes. A simplified analysis is shown in Figure 1.

In the scenario analysis phase, new asset allocations should be developed to arrive at a new optimum allocation. Some asset classes may no longer be viable investment options as compared with other allocations that enable better tax management. The optimum allocation is one that maximizes the after-tax cash flows. As an example, if a client currently has all their assets in growth stocks and has been taking gains to meet their cash flow needs, then a scenario analysis would show that, with higher capital gains rates, more principal would have to be sold to generate the same after-tax cash flows. In this case, the portfolio might benefit from having some dividend paying stocks that do not require selling principal to generate cash flows or from introducing some fixed income into the asset allocation, perhaps tax free bonds. While under the old tax rates, muni-bonds might not have appeared attractive, under the new higher tax rates, their after-tax cash flows might satisfy part of the client's needs.

After the optimum allocation is determined at the portfolio level, then examine the portfolio structure by asset location, i.e., locating the asset class in a taxable versus tax-deferred account and by individual circumstances, for example whether the client is required or eligible to take distributions. This level of analysis requires a personalized, comprehensive approach such as that available from a private client investment manager.

Step 3: Prepare new portfolio characteristics and assess future after-tax cash flows and returns.

Finally, a set of potential asset allocations should be developed using the above scenario analysis and each proposed asset allocation should be compared to the existing portfolio to arrive at the tax costs of any proposed changes.

These tax costs should be measured not only in the absolute sense now, but also should be measured in the future, as if they were implemented post the new tax rates. By taking this final step in comparing the proposed new optimized portfolio allocation with the current allocation and seeing the cost of changes, the CPA/advisor can look into the future and see what the costs would be were the changes not made before the new tax rates are implemented. It is in this final phase that reality usually comes into full focus and brings about the right sense of urgency to take the necessary actions and take them before the higher tax rates are implemented.

It is usually clear as to the direction that a portfolio has to move in advance of the new tax changes and it is usually better to follow a process that concludes with a specific set of proposed actions. While it is not possible to predict with accuracy what the new tax rates will be, it is almost always advantageous to begin this tax analysis process early and have the implementation plans in process before it is too late. You can't stop the tax changes from coming, but you can help your clients make more informed decisions and help them plan their financial futures with greater certainty.

Garrett R. D'Alessandro, CFA, AIF®, is Chief Executive Officer & President of Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high-net-worth individuals and families. For more information, please call 800-245-9888 or e-mail info@rochdale.com.

This publication is for informational purposes only and is not intended to be a solicitation, offering, or recommendation by Rochdale or its affiliates of any product, transaction, or service, including securities transactions and investment management or advisory services. The opinions expressed in this publication should not be considered investment, tax, legal, or other advice and should not be relied on in making any investment or other decision.

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