Managing Taxes Holistically May Improve Tax Efficiency
Key findings
- High-net-worth clients using unified managed accounts and unified managed households often experience tax inefficiencies due to the siloed management of sub-accounts.
- "Wealth managers employing holistic tax management across all sub-accounts may be able to minimize the client's total tax burden while maintaining alignment with their overall investment objectives.
- Our case study showed that employing a holistic approach could have saved a hypothetical wealth-management client an additional 1.3% in U.S. tax liability associated with a requested cash withdrawal.
Many high-net-worth (HNW) individuals in the U.S. use unified managed accounts (UMAs) to consolidate their investment strategies and asset-class exposures into a single portfolio. Similarly, families often employ unified managed households (UMHs) to collectively manage all investment accounts within a household. While these approaches facilitate personalized management and a comprehensive view of assets, they may not provide for tax optimization across the entire portfolio or household. Siloed investment and tax management by sub-account managers often impedes the offsetting of realized gains and losses across accounts, potentially increasing the client's overall tax liability.
A potential remedy is a holistic approach to tax management, which can help wealth managers minimize a client's total annual tax liability, while retaining alignment with the client's investment objectives.
A case study
To illustrate how holistic tax management might work in practice, we constructed a case study of a hypothetical U.S.-based client with a USD 1 million growth portfolio who requests a cash withdrawal. The client directed the manager to sell assets in the U.S. equity sub-account, which has become overweight after recent market moves.[1] To implement the strategy, the wealth manager would adopt a tax overlay in coordination with the client's sub-account managers.
The client's hypothetical portfolio is allocated as follows:
- U.S. equity separately managed account (SMA) (65%): This portfolio seeks to track the MSCI USA Index and holds individual equities. Initial tracking error (TE) = 2.7%,[2] number of stocks = 56.
- International equity SMA (15%): This portfolio seeks to track the MSCI EAFE Index and holds individual equities. Initial TE = 2.5%, number of stocks = 40.
- Fixed-income account (20%): This portfolio holds funds invested in U.S. government, U.S. investment-grade, U.S. high-yield and USD-denominated emerging-market bonds.[3] Initial TE = 4.4%, number of funds held = 6.
Hypothetical unrealized gains and losses at date of withdrawal request
For the current tax year, we assume the sub-accounts have no realized gains or losses.
Our analysis focuses on how withdrawal size might affect potential tax savings. We analyzed withdrawal amounts between USD 100,000 and USD 200,000. These amounts are significant for a USD 1 million portfolio and should provide a meaningful test to measure tax efficiency.
Selling assets only from the U.S. equity sub-account would trigger taxable gains: the sub-account has a substantial unrealized gain of USD 424,796 after harvesting available losses in the previous tax year. Our analysis assesses how holistic tax management could improve upon this result.
Comparing after-tax returns under three portfolio-management approaches
We compared the impact of the requested cash withdrawal on after-tax return (assuming a 15% capital-gains tax rate) under three different portfolio-management strategies, using the MSCI Optimizer:[4]
- Tax-agnostic approach: Assets are sold pro rata from the U.S. equity sub-account without considering any tax implications.
- Single-account approach: Each sub-account rebalances to independently minimize the tax liability arising from the sub-account.
- Holistic approach: A simulated tax-overlay technique coordinates actions across all sub-accounts, aiming to minimize the client's total tax liability.
Hypothetical tax liability and TE comparison under different approaches
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This exhibit is interactive and shows how the tax liability and tracking error change as the withdrawal amount changes under the different portfolio-management approaches: tax agnostic, single account and holistic.
Risk model and price data as of July 1, 2024. We assume a capital-gains tax rate of 15%.
Across investment profiles, tax liability was lower, but at cost of higher TE
Given the trade-off of increased TE, we examine how it could play out for different investor profiles, each with its own priority regarding benchmark alignment and tax efficiency:
- Benchmark-adhering investor: Prioritizes benchmark alignment, with a TE limit of 2% for the U.S. and international equity sub-accounts and 4.5% for the fixed-income sub-account, even if it creates a higher tax liability.
- Balanced investor: Seeks the middle ground between tax savings and benchmark alignment, with a TE limit of 3% for the U.S. and international equity sub-accounts and 5% for the fixed-income sub-account.
- Tax-focused investor: Willing to tolerate higher TE to gain maximum tax efficiency, with a TE limit of 4% for the U.S. and international equity sub-accounts and 5.5% for the fixed-income sub-account.
Tax-liability analysis by client profile
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This exhibit is interactive and shows how the tax liability changes as the withdrawal amount changes under the single-account and holistic portfolio-management approaches for three investor profiles: benchmark adhering, balanced and tax focused.
Risk model and price data as of July 1, 2024.
Coordinating across sub-accounts helped offset gains and losses
Our analysis showed that for a hypothetical U.S. individual taxpayer, holistic tax management across multiple accounts would have reduced tax liability, independent of the client's benchmark-tracking and tax preferences. The potential for tax savings was greater when the investor had the flexibility to offset large unrealized gains in one sub-account against unrealized losses in another. Coordination across all sub-accounts in a UMA or UMH can potentially uncover opportunities to more effectively reduce tax liability.
1 The sub-account is deemed overweight relative to the MSCI World Index, in which U.S. equities constitute approximately 72.7%, compared to 81.3% in the client's U.S. equity SMA at the time they made the withdrawal request.2 We estimate ex-ante tracking error using the MSCI Multi-Asset Class Factor Model.3 The portfolio tracks an MSCI blended fixed-income index, constructed based on the client's investment goals, that consists of the following indexes: 40% MSCI U.S. Government Bond, 30% MSCI USD IG Corporate Bond, 15% MSCI USD EM Sovereign Bond and 15% MSCI USD HY Corporate Bond Indexes.4 The MSCI Optimizer's multi-account capabilities enable users to optimize their sub-accounts simultaneously while aligning with the benchmarks both at sub-account and portfolio levels.5 We calculate the dollar reduction in tax liability, express it as a percentage of the withdrawn amount and average this percentage reduction across withdrawal rates, ranging from 10% to 20%.
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