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“For many advisors and clients, taxes will be the next big thing,” says Glenn Frank, CPA/PFS, MS Taxation, Director of Investment Tax Strategy at Lexington Wealth Management and President of Frank Advising. “The taxes on investors’ portfolios have been hiked up across the board. And right now, tax laws are looking about as permanent as they get.”
That leads to Tax Alpha, a topic on which Frank has written numerous papers and articles. “Determine the average amount of taxes a client would pay on their portfolio over a lifetime. And when you can reduce those taxes to enhance performance — that difference is Tax Alpha,” Frank says. “The more you save on taxes, the more Tax Alpha you create, the more money you can put to work for the client and their family. It adds tremendous value.”
“And to generate Tax Alpha, the power of tax deferral is huge,” says Frank. “I like to quote Albert Einstein, who said, ‘The most powerful force on earth is compound interest.’ To be more precise — tax-deferred compound interest.”
TAXES: KEY TO THE PLANNING EQUATION
In addition to advising clients for more than twenty years, Frank launched a master’s program in financial planning two decades ago and continues to teach. “I love the holistic approach to planning — there’s a natural fit between financial planning, investment planning and tax planning. Taxes are really a common thread that goes through everything.”
After co-launching, helping to build and then sell a successful $2 billion AUM practice, Frank joined Lexington Wealth Management as the Director of Investment Tax Strategy. “Lexington is a very progressive firm — and my role here underscores the importance of taxes. It used to be you had to see your CPA to figure out your taxes. But at Lexington, it’s my job to make sure taxes are a key part of the wealth management equation and the overall financial plan.”
Lexington specializes in high income and high net worth clients, who average roughly $5 million in investable assets, while also serving some clients with $20 million or more. “It’s the high net worth clients who often take the hardest hit from taxes,” says Frank. “But nearly all clients can find ways to benefit from Tax Alpha. It’s fundamental to a comprehensive plan.”
ASSET LOCATION FOR MORE TAX ALPHA
Frank employs a five step process — financial planning, asset class selection, investment vehicle selection, asset location and rebalancing. “Step number four — asset location — is critical yet often overlooked. I’ve used this step throughout my career. Optimizing the location of investments represents an advisor’s greatest opportunity to create tax alpha.”
Research has shown that asset location can dramatically reduce taxes over time and reliably enhance overall performance by 100 bps or more - without increasing risk - as the same investment are being used, just located in the right investment vehicle.
“Just as asset allocation enhances diversification to protect a portfolio from volatility, asset location enhances diversification from the tax perspective,” Frank says. “While it’s very situational — depending on factors like the client’s income and potential capital gains — the savings and subsequent wealth created by asset location can be substantial, especially for clients in high tax brackets and clients with a portfolio of $1 million or more.”
Research has shown that asset location can dramatically reduce taxes over time and reliably enhance overall performance by 100 bps or more — without increasing risk — as the same investments are being used, just located in the right investment vehicle. Start by considering three factors. First, the tax-efficiency of assets — do they generate long term capital gains, short term capital gains or ordinary income? Second, the management style of assets — passive or active? Third the client profile — including age, tax bracket, liquidity needs, and estate planning needs.
Then locate assets based on tax-efficiency. Locate tax-efficient investments such as buy and hold equities, index funds, ETFs, and tax-exempt municipal bonds in the taxable account. Locate tax-inefficient investments such as fixed income, REITS, commodities, actively managed strategies and liquid alts in tax-deferred vehicles such as a 401(k), IRA, 529 Plan or other tax-deferred vehicle.
And for the high net worth, who can easily max out the low contribution limits of qualified plans, variable annuities can be a valuable solution. VAs can make sense when the amount of tax inefficient investments targeted for tax-deferred vehicles is greater than the capacity of a client’s qualified accounts. Frank notes that another advantage of using variable annuities is the ability to defer beyond age 70 ½. Unlike an IRA, VAs have no required minimum distributions.
But only the right kind of VA makes sense. “If the cost is low enough for the math to work, then a VA can be a real win for the investor,” said Frank. This is what drew him to Jefferson National’s Monument Advisor, the industry’s first flat-fee Investment Only Variable Annuity (IOVA). “Jefferson National is truly the top of the class. It checks all the boxes. In most cases, it’s the lowest cost. No one has more funds. No one has better tools or better service. It’s the best way of buying tax deferral for the lowest cost and largest array of asset classes.”
Frank cautions that to get the best value for clients, it’s important to look closely at all of the fees, including the underlying investment options within the VA. In some cases, funds available in the VA may be more expensive than the retail equivalent mutual funds. In other cases fees may be equal to, or even less than the retail equivalent, depending on the specific fund, the fund family and the share class offered by the VA.
THE CLIENT CONVERSATION
When Frank sits down for the first time with a client who is not familiar with asset location, he starts with the five fundamental steps. “We spend time educating the client so they understand each step of the whole planning process — and how asset location fits.”
Then, to make it more concrete, he looks for an obvious deficiency. For example, a client’s high-yield bond made 6 percent — but in their bracket, they lost 2 percent to taxes.
From there, he explains the impact of taxes over time. “At 6 percent, the client’s money is going to double every 12 years,” says Frank. “But if they lose 2 percent to taxes, then it takes 18 years to double — 50 percent longer.”
“Play that out over several decades — the cost of taxes versus the benefits of asset location — and it really resonates. Clients can immediately understand. And they want to know more.” Many clients see an additional benefit. “Asset location can create enough Tax Alpha that some clients are able to pay for our entire advisory fee every single year through the extra tax savings.”
And how to explain the costs to a client if they don’t use asset location? “It’s simple,” Frank says. “They’re either going to have to take on more risk to generate more return. Or they’re going to end up working for more years.” There’s a very direct relationship between paying out more in taxes each year — and earning lower returns.
“The tax drag impacts clients on a long-term basis. But using asset location is a proven solution to increase Tax Alpha — and increase returns — without increasing risk.” That means more wealth for your clients, even when confronting today’s higher taxes, lower yields and ongoing volatility.
ABOUT GLENN FRANK
Glenn Frank, CPA/PFS, MS Taxation, is Director of Investment Tax Strategy at Lexington Wealth Management. He is also is the President of Frank Advising, which provides guidance on the tax side of investing to advisors and individual investors. Mr. Frank has over 25 years of experience in taxes, investment consulting and financial planning, and for 10 consecutive years he was recognized in Worth Magazine’s rankings as one of the country’s top Wealth Advisors. The Founding Director of the Master of Personal Financial Planning program at Bentley University, Mr. Frank is a member of the program’s advisory board and continues to teach. He also serves on the Client Advisory Board of State Street Global Advisors, is a frequent speaker, and has been quoted in publications such as the Wall Street Journal, The Boston Globe, Sumnews, Advisor’s Perspectives, Financial Planning and Investment News.
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