After-tax allocation strategies for high net worth clients

What advisors need to know

• As wealthy investors become increasingly focused on tax costs, advisors will need to prioritize tax efficiency in order to compete for high net worth clients.
• You can take measures to reduce tax costs within bonds as well as stocks, but optimal after-tax returns considers the interdependencies of assets across the whole portfolio.
• Show clients how their portfolio is designed with the goal of maximizing after-tax returns and how much you are saving them in taxes.

High net worth investors are increasingly focused on after-tax returns

If you serve high net worth clients, you’re likely having more conversations about tax efficiency these days. Innovation in financial markets has wealthier investors thinking about new ways to reach for higher after-tax returns, particularly as increasing tax costs loom on the horizon. Unless Congress intervenes, the expiration of multiple tax cut provisions at the end of 2025 is expected to result in higher income tax rates and a dramatically reduced estate and gift tax exemption. The impact of these changes could be significant for the many families who will be transferring an estimated $73 trillion of assets from one generation to the next over the coming 20 years.¹

Advisors have a timely opportunity to deepen loyalty, earn referrals and attract new clients by demonstrating how they increase after-tax wealth for their high net worth clients. Advisory teams that focus on serving the high net worth segment identify tax minimization as the second most important investment goal for their clients, following wealth preservation, which is also served by minimizing taxes.

Tax minimization is a critical objective for high net worth investors
% of high net worth teams that identify objectives as very important for their clients

While only 45% of high net worth practices currently offer tax planning, it has been the fastest-growing addition to high net worth practice service models in the past five years.² Many advisors are seeking advanced tax education to remain competitive in the high net worth space. Following a recent announcement that the American College of Financial Services would be rolling out a new Tax Planning Certified Professional program, more than 2,000 advisors had joined the wait list within the first week.³ To be successful as a high net worth advisor, you don’t have to be able to file tax returns for your clients, but you do have to provide optimal portfolios for taxable accounts.

Use after-tax allocation strategies to stand out from competitors

The first line of defense in the pursuit of higher after-tax returns is to optimize the placement of assets across tax-free, tax-deferred and taxable accounts, commonly referred to as asset location strategies. But given that tax-advantaged accounts have contribution limits, the majority of assets for high net worth and, especially, ultra high net worth clients are likely to be held in taxable accounts. This is where after-tax allocation strategies can reduce your clients’ tax costs and help you stand out among your competition.

Many advisors still invest without an up-front consideration of taxes, using risk and pre-tax return as the key, if not only, factors in their allocation decisions. Adding taxes to the equation means that all returns need to be analyzed on an after-tax basis. However, projecting the impact of taxes on future portfolio returns can be challenging, especially given the complexity of tax law, its variation over time and the wide range of its effect across different asset classes. Investing on an after-tax basis requires more time, effort and expertise, but the cost of ignoring taxes can be significant for your clients and, likewise, for your business. 

Tax considerations change the asset allocation

Certain asset classes look very different in the pre-tax and after-tax investing worlds. Bonds provide a familiar example: A comparison of tax-equivalent yield determines whether a client should hold an allocation to taxable bonds or tax-exempt municipals. If you have applied this method in your client portfolios, you have already taken a step into the after-tax investing world. 

A similar comparison of pre-tax and after-tax returns can be applied across all asset classes and the differences can be particular notable in some, such as private equity and private credit. In taxable accounts, a private equity fund can offer the potential for attractive returns on an after-tax basis as they often do not trigger gains or other income for many years, and even then, such income is frequently taxed at the lower long-term gain rate. In contrast, private credit as well as some high yield taxable debt tends to generate income on an ongoing basis that is taxed at the highest rate, which may make those assets compare less favorably on an after-tax basis than pre-tax.

Turning back to public markets, the various available equity strategies also look different through an after-tax lens. If you want to increase your focus on after-tax investing, your stock allocation can be a good place to start.

Apply an after-tax mindset in your stock allocation

Within stocks, you will need to evaluate tradeoffs between traditional actively managed mutual funds, index exchange-traded funds (ETFs), actively managed ETFs and direct indexing separately managed accounts (SMAs). The right mix of these investment vehicles and mandates considers the correlations and volatility of the investments and the extent to which other exposures in the portfolio can offset their risks.

• Actively managed mutual funds can offer attractive potential returns but also tend to be the least tax-efficient equity vehicle. Over the past five years on average, 76% of U.S. active equity mutual funds distributed capital gains at amounts averaging a sizable 7.2% of their net asset values.⁴ Accordingly, active equity mutual funds are ideally held in a tax exempt account; however, they may still be attractive in a taxable account if you know how to pick a fund manager who can potentially generate a level of return that exceeds the tax costs by an amount that justifies the investment risk.

• Index ETFs can be a better investment when equity assets are held in a taxable account. Equity index ETFs that are efficiently managed typically distribute little to no capital gains to their shareholders, creating little to no ongoing tax liability.

• Active ETFs provide the potential for outperformance with the benefits of an ETF wrapper, including tax efficiency and transparency. They can be a good choice for taxable accounts when you are seeking to outperform the market, deliver a specific outcome or gain exposure to a hard-to-index market. The in-kind creation and redemption process used by some active equity ETFs serves to limit the number of taxable events that occur within the fund, which can make them more tax efficient than their mutual fund peers. Actively managed mutual funds, by comparison, offer a larger universe of investment mandates and have the ability to hold illiquid investments and use certain derivative strategies that are not possible in active ETFs.

• Direct indexing SMAs seek to provide exposure to a benchmark through the direct ownership of individual stocks while seeking to outperform on an after-tax basis by tax loss harvesting (i.e., generating tax losses that can offset the investor’s taxable gains). Holding a direct indexing SMA in a taxable account can have a positive impact on a client’s overall after-tax returns when there are realized gains elsewhere in the portfolio.

Consider the whole portfolio for optimal tax after-tax returns

You can take measures to reduce tax costs within your bonds and your stocks, but seeking optimal after-tax returns requires consideration of the whole portfolio within the context of the client’s complete tax situation. An effective after-tax allocation accounts for the interdependencies of all possible asset classes with consideration of their correlations, risk, expected returns and tax implications for the particular client. Put simply, optimizing a client’s after-tax return potential requires an asset allocation process that accounts for risk and after-tax returns. If you want to take a deep dive into the mechanics of after-tax allocation, read ‘What Would Yale Do if it Were Taxable?’

Choose your approach to after-tax investing

To compete for high net worth clients, it’s important that you provide portfolios that are optimized for after-tax returns, and there’s more than one way to do it.

If you prefer to build your own portfolios, be sure to weigh the tradeoffs of how you spend your time. Constructing personalized portfolios optimized for after-tax returns would likely consume a significant portion of your time that you could be spending with clients or focusing on your business growth goals. Advisors who opt for the do-it-yourself approach typically focus on their top-tier clients while creating scale across smaller client accounts by using models, delegating to a junior advisor or hiring a third-party investment manager. 

Alternatively, you can provide clients with after-tax optimized portfolios using customizable tax-aware models. Tapping into advanced technology allows you to 1) transition existing portfolios into models easily and tax efficiently, 2) automate rebalances and tax loss harvesting in your portfolios, and 3) generate performance reports you can share with your clients. Automating tax management in your portfolios lightens the lift for you significantly, so you can dedicate more time to solving your best clients’ biggest problems outside of the portfolio. 

Show clients how you reduce their tax costs

Your clients won’t value your focus on tax efficiency if they don’t know about it. Talk about taxes in meetings with your high net worth clients. Show them how their portfolio is designed with the goal of maximizing after-tax returns and how much you are saving them in taxes, which means more wealth for them.

BlackRock can help you grow your tax expertise and your business. Explore our online resources and tools to learn how you can prioritize tax efficiency to attract high net worth clients.

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