Tax efficiency is becoming increasingly important for clients, and essential for advisors wishing to build their practice, especially among tax-sensitive high net worth (HNW) investors. Tax law is complicated, but tax-efficient investing doesn’t have to be — if advisors approach it systematically and in partnership with a client’s legal and tax professionals. We have developed a simple framework, which we call SMART, as a helpful starting point for financial advisors looking to enhance tax efficiency within your practice.

S — Stay focused on objective

Always keep the end goal in mind. Although it may sound obvious, tax efficiency should be considered in the context of the client’s financial goals —not myopically pursued for its own sake. If advisors become overly focused on reducing tax liabilities, they risk losing sight of the client’s investment objectives.

Don’t let taxes be the “tail that wags the dog.” If minimizing taxes becomes the sole focus, the asset allocation could quickly become misaligned to client objectives and risk tolerance. Take an investor with a growth-and-income objective. Moving a chunk of their equities and high-yield fixed income into municipal bonds may help lower their tax bill, but at the expense of their objectives. Equities can provide the price appreciation they need for growth, while high-yield bonds can generate higher coupon income. Advisors may need to educate especially tax-averse clients on how to balance tax efficiency against their overall goals. 

M — Maximize after-tax returns

It’s not simply about avoiding taxes. While no one enjoys paying taxes, owing capital gains tax can be a good problem to have. It indicates your strategy of investing for growth is working. Tax-efficient investing is about maximizing after-tax returns consistent with client objectives, not simply reducing immediate tax liability. 

A — Asset and vehicle allocation and location

Factor taxes into asset allocation. Although taxes should not be the sole driver of strategic asset allocation, they should be considered given their potential impact on after-tax returns. Look for asset types that align to your client’s objectives and have tax efficiency. Municipal bonds, individual stocks (with mostly qualified dividends) and tax-managed funds or model portfolios are examples of more tax-efficient assets.

Use asset location to boost tax efficiency. Optimizing asset location has the potential to generate meaningful tax alpha (the additional return investors can realize by implementing effective tax strategies). If asset location is truly optimized, different types of client accounts (taxable and tax-advantaged) should generally hold notably different types of asset classes and vehicles. If the client’s various accounts have similar asset allocations and risk profiles, that could be a sign the client is missing out on potential tax alpha.

Hold the right kinds of assets in tax-advantaged accounts. Although asset-location decisions can vary based on a client’s personal and financial situation, here is a good rule of thumb: Tax-efficient assets generally should be held in taxable accounts, while tax-inefficient assets should generally be held in tax-advantaged accounts. Since some tax-advantaged accounts come with contribution and/or income limits, consider prioritizing the least tax-efficient assets first for placement in tax-advantaged accounts. Tax-inefficient investments are those that generate more frequent or impactful taxable events, such as high levels of ordinary income, like high-yield bonds, private credit, real estate investment trusts or stocks paying lots of nonqualified dividends. More tax-efficient assets like equities (with qualified dividends), municipal bonds and tax-managed funds and model portfolios are well-suited for taxable accounts.

Product and vehicle allocation matters. Exchange-traded funds (ETFs) entail greater tax deferral because they tend to generate fewer capital gains than mutual funds, which often create distributions for investors when investment companies sell underlying holdings to meet investor redemptions. In contrast, when an investor sells ETF shares, transactions mostly occur in the secondary market. When selling activity on an exchange results in a redemption from the fund, it is usually tax-free to remaining investors, because redemptions are often accomplished in the primary market via an in-kind delivery of securities to an intermediary. (The in-kind delivery is not a taxable event.) Since ETFs are more tax-deferred, they are well-suited to taxable accounts. To pursue greater after-tax returns, consider the potential benefits of actively managed ETFs, which can pursue excess returns in a more tax-efficient manner. Active ETFs can also pursue distinct investment objectives, like income or a combination of growth and income, that better align to clients’ real-world goals.

Maximize the benefits of separately managed accounts (SMAs). In an SMA, clients own the securities, whereas they have indirect ownership of investments within ETFs and mutual funds. Because clients own the investments directly, the structure of an SMA gives investors more flexibility to time and control taxable events by strategically harvesting losses from investments to offset the tax impact of selling more lucrative ones, when applicable. SMAs also provide clients more control and customization of the portfolio to ensure it better aligns with their objectives, risk tolerance and goals. In addition, the combination of SMA and tax-loss harvesting can help a client to gradually transition assets to a new investment strategy in a more tax-efficient manner.

R — Rebalance with taxes in mind

Portfolio rebalancing is a key risk management tool because it helps maintain a target asset allocation, control risk exposure and prevent emotional decision-making. By systematically selling investments that have grown beyond their target weight and buying those that have underperformed, rebalancing enforces a “buy low, sell high” strategy, reducing overall portfolio risk. It also helps an investor stick to a long-term plan, especially during market volatility.

Look for ways to rebalance that can help mitigate the tax impact of buying and selling investments. Two examples:

Rebalance qualified accounts first. As much as possible, try to rebalance within tax-advantaged accounts as trading within those accounts doesn’t generate capital gains taxes. Rebalance qualified accounts more frequently.

Use cash flows to rebalance. If clients have new cash coming in, consider using that to purchase assets to help rebalance their portfolio. For example, if strong equity gains have thrown a 60/40 portfolio off course, use new cash flows to purchase fixed income or other assets with lower equity correlations. Similarly, coupon and dividend payments can be reinvested to help rebalance portfolios.

T — Tax optimization and implementation

Maximize opportunities for tax-loss harvesting (TLH). Consistent TLH is table stakes in today’s marketplace. If advisors are only harvesting losses at year-end, they are missing out on ongoing opportunities for tax alpha. Tax overlay services can help pursue this potential tax alpha. These services use technology to increase the effectiveness of TLH relative to more manual or periodic checks, which may miss intra-quarter opportunities for TLH. With overlay services, tax-loss sales are automatically executed once specified thresholds are crossed. Evaluate each client’s situation to determine whether the benefits of the service would outweigh the extra cost.

Consider actively managed strategies alongside direct indexing. Direct indexing seeks to replicate a market index’s performance by buying a representative sample of securities. An investor can then harvest losses on those securities as opportunities arise. Direct indexing can also help diversify concentrated portfolios. However, the TLH benefits of direct indexing can diminish over time, primarily because the opportunity to harvest losses declines as the portfolio value grows, limiting the number of stocks with losses that can be sold to offset gains. Although direct indexing is most often associated with these services, overlays can also be accomplished with actively managed strategies. With active strategies, the service sells investments for TLH but replaces them with similar securities from a universe approved by the active manager. An active strategy can seek to outperform market indexes or pursue distinct investment objectives, like growth and income, that are closely linked to clients' real-world goals.

Donate appreciated stocks to remedy highly appreciated concentrated stock positions. Many clients hold concentrated stock positions that they have accumulated through their company or by other means. In addition to creating a large tax bill when these low-cost-basis shares are sold, these concentrated positions can also reduce portfolio diversification. To address this issue, explore the potential tax savings from gifting appreciated stock directly to charity instead of selling assets to generate cash for donations. For clients with philanthropic goals, this can be a great way to help them begin planning for charitable giving.

Enhance the tax benefits of charitable giving. Clients with greater net worth may have more opportunities and tools for using charitable donations for tax benefits. For example, a donor advised fund (DAF) can help reduce taxes on income windfalls a client occasionally receives. A DAF is an account to which a client can irrevocably gift assets to a designated charity. Although the client no longer owns the donated assets, they do control when they are distributed to the charity. For example: A client donates $5,000 a year to their favorite charity but they receive unusually high income this year. The client could potentially reduce their tax liability for the current year by depositing $50,000 worth of assets for the charity in a DAF. The client may be able to deduct some or all of that amount now and then distribute $5,000 annually from the DAF to the charity in future years.

Other options to explore include a charitable remainder trust — an irrevocable trust that could allow a client to donate assets to charity and draw annual income for a specified period, or a qualified charitable distribution (QCD). A QCD allows an individual 70 ½ or older to donate directly from their traditional IRA to a qualified charity; this may allow the client to meet some or all of their required minimum distribution (RMD), potentially reducing their taxable income. It's important to consult with the client's tax professional when considering these kinds of charitable giving tax strategies. To help start conversations with clients, this investor-facing brochure on How to make the most of your charitable giving can be a great pre-read to share with them.  

Putting it all together

Minimizing tax liabilities should be one facet of helping investors achieve their goals, not an end unto itself. Understanding a client's specific tax liability and investment objectives is crucial to determine the appropriate tax strategy. Optimizing portfolios for tax efficiency can help investors maximize potential after-tax returns to help them achieve their investment goals.