How a tax overlay manager helps financial advisors

Financial advisors who may be struggling to manage the capital-gains exposure across tens or even several hundreds of client portfolios could hire a “tax overlay manager” to help.

Short-term capital gains incur a tax hit of upwards of 50% in states with the highest income duties — which can be quite a “negative surprise” for clients whose investments have performed well, according to Erik Preus, the group head of investment solutions at Envestnet | PMC. 

Giving discretion to an outside firm such as Envestnet, whose tax overlay service typically costs around 10 basis points, ensures savings that are far above the fee by carrying out loss-harvesting and rebalancing across unified managed accounts, Preus said in an interview. The Berwyn, Pennsylvania-based advisor technology and asset management firm is one of several that help busy planners lock in after-tax returns through various forms of optimization.

“The reason that it’s important to go to an overlay manager is it’s very difficult for a financial advisor to do that when they have over 200 clients,” Preus said. “You outsource to an overlay manager, and you really bring scale to your practice while adding value to the client.”

READ MORE: Taxes + wealth: 2 connected but still (for now) distinct fields are merging

More industry resources and research are delving into tax planning for investment portfolios — which is distinct from preparing returns and directly involved with traditional wealth management services. Tax “leakage” from hits to investment portfolio returns amounts to $600 billion in missing potential yield each year, according to an estimate by wealth management firm Avantax. 

Behavioral coaching, asset location and spending and withdrawal strategy — each of which relate to taxes — comprised the three largest areas of value in the latest version of the Vanguard Advisor’s Alpha report in 2022. For example, the possible advantages from tax-smart asset location could add up to as many as 60 basis points for some investors, the report said.

In this year’s edition of a book by Bill Harris, the “Investment Tax Guide,” the former CEO of Personal Capital, Intuit TurboTax and PayPal argues that “Tax is the single most important driver of investment performance” and “In many cases, tax strategy is more important than investment strategy.”

“By using the right tax strategies, you can slash the taxes on your investments from as high as 50% to as low as zero,” Harris wrote. “This may surprise you, because no one in the investment industry ever tells you about taxes. Not brokers, not financial advisors, not firms selling mutual funds and ETFs. Everyone talks about pre-tax returns — the money you make before you pay taxes. No one talks about after-tax returns — the money you actually keep.”

READ MORE: Envestnet CEO departure sparks call for streamlining

The tax overlay service represents another way that wealth management firms are increasingly working in both fields to some degree, whether through mergers like the one that brought Preus to Envestnet from Placemark Investments in 2014 or expanded capability launches.

“Incorporating that focus on the impact that taxes have on your after-tax performance we think is an important part of an advisor’s role but also part of a compelling value proposition to clients that can deepen client relationships,” he said. “It’s exploding in growth. I think there’s been a natural evolution in our industry over the last 20 years.”