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We manage the flow of rivers to protect valuable land assets from constant erosion. Likewise, tax-savvy financial professionals work to manage the flow of taxes to prevent the erosion of client portfolios.
Recently, we’ve considered whether protected investments function as an asset class. It’s just as important to analyze the protection from taxation offered by annuities, and the advantages it offers to increasing investment portfolio alpha.
Taxes have to be paid — like a river, you just can’t stop them. But you can help manage them. Here are a few things your clients can think about and discuss with their tax advisor to help protect their portfolio, whether they are focused on growth, income or leaving a legacy.
Taxes, the other silent portfolio killer
Inflation steadily eats away at the real value of client assets every year. It’s a silent killer of true portfolio return and something entirely out of our control. Over the past year it has been at its worst in decades and according to the Alliance, 8 out of 10 clients are concerned about inflation reducing their spending power in retirement.
The other silent portfolio killer we do have some control over is taxes. If your clients have expressed concern about the amount of taxation generated by their portfolio, they are in good company. Research found that “nearly 80% of investors believe their advisors should be focused on minimizing their tax obligations and 90% agree that taxes can erode their portfolios over time.”
Unlike inflation, projecting the long-term impact of taxes isn’t always as clear as we would like it to be. One surefire thing is clear, not paying taxes is better than paying taxes!
Tax efficiency is a form of portfolio protection
The Alliance for Lifetime Income released a comprehensive study that found 89% of investors ranked protection — defined as providing guaranteed income or reducing asset loss — as moderately or very important, whereas only 73% of financial professionals ranked it as important. Are clients and their advisors on the same page when considering the impact of taxes on "reducing asset loss"?
Another survey found that “nearly 80% of investors believe that advisors should be focused on minimizing their tax obligations and 90% agree that taxes can erode their portfolio over time.” A similar number believe it’s easier to explain the tangible benefits of effective tax management than to explain outperforming the market, however, as few as perhaps 20% of advisors actually use automated tax management with their clients.
Tax math is a drag…but let’s take a (re)balanced look
Let’s take a look at how taxes can eat away at an investment portfolio. The annual erosion caused by various forms of taxation is known as “tax drag.” This tax drag will be higher if the timing and rate of taxation — on money being invested for the future — isn’t properly managed.
This article takes a closer look at the math behind the tax drag and the tax cost ratio. Each year U.S. equities lose an average of 1.8% to taxes, while international equity and fixed income loses 1.3%. It might not seem like a lot, but the average tax cost ratio is considerably more than the average fund expense ratio—for U.S. equities, more than double. And the problem just gets worse over time. To put it in perspective, over a recent five-year period: “a balanced portfolio consisting of 30% US equities, 20% international equities and 50% fixed income would have given up nearly the entire pre-tax return of 1.9% to taxes and delivered just 0.3% after accounting for this tax drag.”
In recent years, this relentless erosion has become more of a concern:
“Each calendar year, investment portfolios of all sorts need to pay taxes on their realized capital gains. Looking just at U.S. mutual funds, 81% paid a capital gain distribution in 2021, with the average distribution at 12% of net asset value (NAV). That was the highest level in 20 years! Those distributions are taxable and can result in a hefty tax bill. It’s also important to note that these distributions can happen in both up and down markets. That’s a little like adding insult to injury. Some of your clients could see negative returns in their portfolios and even so receive a Form 1099-DIV with a big tax bill due in April.”
When your clients need to rebalance their portfolio to sell off strongly performing investments (without the proper pre-planning) the tax drag can certainly put a damper on your ability to practice good investment management, let alone respond nimbly to the market. There are simple solutions to many of these taxation problems.
From my perspective, tax-free rebalancing is the single most overlooked benefit of an annuity or retirement plan. Outside these savings vehicles you can control taxes to a great degree by carefully selecting your investments. But in many cases, the best option for managing taxes isn’t the best fit for your portfolio strategy, especially if you are making rapid tactical adjustments in the face of volatility. In almost all cases it is impossible to rebalance those investments without having to pay a share to Uncle Sam.
Protecting retirees and families from bearing the full brunt of taxes
Tax-free exchanges and tax deferral are powerful tools to manage retirement assets. Of course, that tax bill is going to come due at some point, and so your client’s challenge is to continue to control the impact of taxes on their income and legacies. Retirees on a fixed income especially need a higher level of protection from too much taxation.
Investors take their income seriously, and the stakes become much higher as they approach retirement. The Alliance study found that 42% agree that they would leave their financial professional if they found that all the possible strategies for producing income in retirement were not presented for consideration. Only 9% disagreed. When they retire — and in 2024 we are going to see the biggest wave of Americans hitting age 65 — even if they have multiple financial professionals and accounts, chances are they’re going to be looking for the one professional who understands retirement distribution on a profound level, including issues with taxation.
Uncle Sam wants to encourage creating a lifetime stream of income. One especially effective strategy for nonqualified assets is the beneficial tax exclusion treatment. An often-cited drawback of annuities is that taxes are paid “last in, first out” (LIFO) on gains in the contract. The principal is last to be taxed. With a tax exclusion ratio, even if there are gains in the contract, your payments consist of both cost basis and taxable gains, until your cost basis has been returned. You have to pay the taxes, of course, but by deferring taxes until retirement and then spreading out the tax burden over your retirement, you can make it more manageable.
If you’ve spent much time doing business with Lincoln Financial Group, chances are you have heard about our unique strategy for dealing with taxes — without losing control of your client’s assets and death benefit.
It’s also a versatile tool for a broad range of unique income and legacy planning situations, including:
- Tax-advantaged lifetime distributions from an inherited nonqualified annuity
- Tax-advantaged gifting of lifetime income
- Income protection through a Special Needs Trust
- Penalty-free income payment before age 59½
- Joint income for someone who isn’t a spouse
- Generational income
Tax-smart income that takes the cake
If it can be tax-efficient, it should be tax-efficient
Here at Lincoln, we’re dedicated to giving you the tools and strategies to take action, whether your clients are growing their assets, taking retirement income or leaving a legacy for their loved ones.
With Tax Day 2024 fast approaching, many of your clients may be eager to discuss how to alleviate their tax burden. As a wise friend often said, “it’s not what you have that matters — it’s what you keep.” These tax calculators can help your clients get a clearer picture.
To read other blog content like this, visit Lincoln's informed financial professional blog.
Related: Investing in Turbulent Times: A 2023 Recap and 2024 Outlook with Matt Berger
Lincoln Financial Group® affiliates, their distributors, and their respective employees, representatives and/or insurance agents do not provide tax, accounting or legal advice. Please consult an independent professional as to any tax, accounting or legal statements made herein.
Variable annuities are long-term investment products designed for retirement purposes and are subject to market fluctuation, investment risk, and possible loss of principal. Variable annuities contain both investment and insurance components and have fees and charges, including mortality and expense, administrative, and advisory fees. Optional features are available for an additional charge.
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Lincoln annuities are issued by The Lincoln National Life Insurance Company, Fort Wayne, IN, and distributed by Lincoln Financial Distributors, Inc., a broker-dealer. The Lincoln National Life Insurance Company does not solicit business in the state of New York, nor is it authorized to do so. Contractual obligations are subject to the claims-paying ability of The Lincoln National Life Insurance Company.
Contracts sold in New York are issued by Lincoln Life & Annuity Company of New York, Syracuse, NY, and distributed by Lincoln Financial Distributors, Inc., a broker-dealer. Contractual obligations are subject to the claims-paying ability of Lincoln Life & Annuity Company of New York.