How Tax Efficient Wealth Management Can Maximize Your Long Term Gains
In addition to comprehensive wealth management, HWM is now offering Ultra Tax Efficient Wealth ManagementSM for suitable clients.
Tax efficiency plays a crucial role in building wealth. Put bluntly, the only way to legally avoid paying taxes is to not make any money–which is not an approach we’d recommend.
That said, taxes can be a large burden on wealth building, and there are legal ways to minimize that tax burden while making lots of money.
In fact, investors have been trying it for as long as the stock market has been around. That’s why strategies like buy and hold, 1031 exchanges, and tax loss harvesting exist–and why individuals often take advantage of options like IRAs, donor-advised funds, and more.
Rather than go into all the ways those strategies lack, today we’re focusing on a new-to-market solution that combines the power of compounding returns with tax deferrals to help investors with highly concentrated or appreciated portfolios minimize their tax burden and see their wealth grow at a higher rate: Ultra Tax Efficient Wealth ManagementSM.
The Power of Tax Deferral: How it Works and Why it Matters
The Compounding Advantage of Tax-Deferred Accounts
Tax deferral, which is available to all HWM clients, is a powerful tool for building wealth.
Capital gains taxes are only incurred when an asset–a stock, business, piece of real estate, etc.–is sold, which means your investments are able to grow tax-deferred in your accounts until that point.
As shown below, over a long holding period, deferring taxes (and paying them when the gains are realized at the end of the period) leads to significantly more net worth for investors than paying taxes annually.
The Power of Tax Deferral
$1m portfolio: End value over different holding periods (assumes 10% pre-tax annual return and 30% tax rate)
The graph above is an illustration of mathematical principles used to demonstrate the impact of taxes and compounding on returns. Returns and tax rates are not reflective of any actual or expected investment outcomes or tax rates. Actual results cannot be guaranteed and will vary.
SOURCE: HWM calculations (available upon request)
Deferring taxes magnifies the already powerful benefit of compounded returns over a long period of time.
The downside of tax deferral is that in order to continue to enjoy the benefits, the assets have to be held over the investor’s lifetime–taking rebalancing, reallocation, and the opportunity to enjoy spending your growing wealth off the table.
It would be appropriate to perceive this as an unacceptable cost, but most investors have just grown accustomed to it because until now there has been no other way to avoid losing meaningful portions of wealth to taxes.
Tax Loss Harvesting as a Tax Deferral Strategy
How to Reduce Investment Taxes and Maximize Wealth
Another option to increase tax efficiency, assuming you have multiple holdings in your investment (such as a basket of stocks versus single address real estate) is tax loss harvesting.
Tax loss harvesting is an important strategy for selling appreciated assets and minimizing the associated tax bill. It involves selling positions with values below their original cost, and using these losses to offset realized gains.
At Hendershott Wealth Management we have always employed tax loss harvesting on behalf of our clients when conditions permit. However, traditional tax loss harvesting is generally limited to times of market weakness–and by the fact that the stock market tends to go up over time.
Eventually, and sometimes very quickly, we expect all of HWM’s client positions to have substantial unrealized gains, eliminating the opportunity to tax loss harvest altogether.
That’s why we’re excited to share that Hendershott Wealth Management is now able to offer a potentially much more effective way to reduce capital gains taxes.
Tax-Efficient Investments: Reducing Capital Gains and Maximizing Returns
How Tax-Advantaged Investments Can Help You Keep More of Your Wealth
The strategy, which we refer to as Ultra Tax Efficient Wealth ManagementSM (UTEWMSM), is a highly effective, time-tested, systematic investment approach that’s implemented by a third party manager in a separately managed account. It uses long/short equity strategies to allow investors to compound wealth more efficiently, and has been developed over 25 years of investment management research and experience.
Ultra Tax Efficient Wealth ManagementSM is designed to help investors build, diversify, and preserve wealth with a tax-first approach.
UTEWMSM aims to generate market-like portfolio returns in a strategy which includes short positions that produce consistent tax losses. The overall strategy is a sophisticated market-neutral, long-short portfolio overlay, including actively harvested tax losses at the security level.
Let’s illustrate what we mean by this with a simplified example.
Imagine you made two bets: one $5 bet that it will rain tomorrow, and one $5 bet that it will not rain tomorrow. When tomorrow comes, you are guaranteed to win one bet and lose the other.
In the real world, this win/loss would cancel each other out and you’d end up with $0. But when it comes to taxes, the accounting is done a little differently.
In an investment account, you can recognize the loss and use it to offset wins elsewhere, canceling out the taxes you would have had to pay on those wins–while NOT realizing the gains from your winning rain bet.
Your pair of bets technically broke even, but according to the tax man (assuming you harvest the loss), you lost money.
The simple example of betting on whether or not it will rain would get resolved and paid out almost immediately. The winning rain bet triggers a “realized gain” that would offset the losing rain bet–you would hand someone a $5 bill to pay them for your losing bet, and someone else would hand you a different $5 bill to pay you for your winning bet. Both your bank account and your tax return are unchanged.
But when it comes to financial investments, things are different.
When you own stocks, you generally have winners and losers–and when you have both long and short positions, you are pretty much guaranteed to have winners and losers whether the market is rising or falling.
Ultra Tax Efficient Wealth ManagementSM takes advantage of these perennial market characteristics:
- Some individual stocks will fall despite a rising market.
- Most short positions incur losses in a rising market.
- Many long positions incur losses in a falling market.
Like the rain bet, you are set up to win some and lose some. And, unlike the rain bet, you can control when you take losses and gains.
By being both extremely sophisticated and strategic, Ultra Tax Efficient Wealth ManagementSM allows investors to realize losses quickly while potentially deferring gains indefinitely–and as we saw illustrated in the chart above, tax deferral has a big impact on long-term wealth building.
Why Ultra Tax Efficient Wealth ManagementSM is a More Powerful Wealth Building Strategy Than Tax Deferral
Using Long/Short Strategies to Legally Reduce Capital Gains Taxes
Let’s apply this theory to a hypothetical investor with a $2 million diversified portfolio in a year where the market goes up 10%. Ignoring dividends and not selling any positions, this investor is able to defer the $200,000 gain and pay no taxes–but an Ultra Tax Efficient Wealth ManagementSM strategy can do better.
To accomplish the strategy, the third party manager might add a $2 million long-short overlay to the core $2 million portfolio. On behalf of the investor, the manager would use leverage to finance a $1 million S&P 500 ETF short position along with $1M invested in the 500 individual stocks comprising the S&P 500.
The net result is the account contains the same stocks both long and short. The investor will then hold these two leveraged positions in addition to the $2 million diversified portfolio ($4 million in gross positions).
The leveraged long and short positions are “market neutral,” meaning the combination makes zero profit regardless of what happens in the stock market.
If the market goes up, the short sale loses money but the individual stocks make money. If the market goes down, the short position makes money, but the individual stocks lose the same amount.
The market-neutral long-short overlay is designed to have no impact on portfolio returns. Our $2 million investor still has $200,000 in gains after a 10% positive year.
There are, however, losses embedded in parts of the overlay, even when the market goes up. If the broad market returns 10%, the short ETF position loses $100k (offset, of course, by $100k of profit from the 500 individual long positions).
Further, although the broad market is up, history suggests many of the 500 individual stocks may be down. For the purposes of this example we are using a 75/25 ratio (positive returns to negative returns), which means within the long overlay, there will be $150k of profits and $50k of losses (aggregating to the $100k gain).
Selling the stocks that have declined along with closing out the short position in this example creates $150k in losses despite the overall portfolio having a $200k gain!
Of course, in this example, the investor’s portfolio now has $350k of deferred gains ($200k from the core portfolio of diversified mutual funds and ETFs plus $100k from the long overlay) instead of $200k–so if the investor liquidates their entire portfolio after a year, there is no tax benefit.
But as we saw in our earlier example, if the investor continues to defer these gains in a longer-term strategy, the effective tax rate falls over time: after 40 years from 30% to single digits. Additionally, the step-up in basis currently available on inheritances makes it possible for future generations to avoid taxes altogether.
In practice, Ultra Tax Efficient Wealth ManagementSM supercharges this simplified example by using individual positions on both sides of the market neutral long-short overlay, as well as potentially trading in the core portfolio. It’s a complicated process–and not something we suggest you try at home.
Ultra Tax Efficient Wealth ManagementSM utilizes sophisticated technology that allows investment professionals to closely monitor the separately managed accounts. There are modest fees associated with financing, managing, and trading the strategy, but for suitable investors, the tax benefits of a well-designed Ultra Tax Efficient Wealth ManagementSM strategy are expected to vastly outweigh the costs.
Is Ultra Tax Efficient Wealth ManagementSM Right for You?
How High Net Worth Investors Can Use UTEWMSM to Diversify Concentrated Stock Positions and Reduce Taxes on Highly Appreciated Assets
Ultra Tax Efficient Wealth ManagementSM is particularly valuable for investors with large, concentrated, and highly-appreciated stock positions they need to diversify over time.
For example, let’s look at another hypothetical investor: an early employee at a successful Silicon Valley startup. Around the time of the startup’s IPO, this investor has $16m of a single stock that is virtually all unrealized gains–plus $4m in other financial assets.
The individual’s investment portfolio, with 80% in a single stock, is very risky. However, realizing the deferred gains to diversify is very expensive–selling one-half of the single stock position would trigger roughly $2.4m of capital gain taxes in a high-tax state like California, and the portfolio would still be risky!
In these cases, realizing capital gains has a large diversification benefit but sacrifices the large tax deferral benefit.
It seems like you can’t have your cake and eat it too… but you can! Ultra Tax Efficient Wealth ManagementSM provides a path for investors to get the benefits of diversification without bearing the large tax cost from realizing gains.
Remember: The market neutral long-short overlay can be expected to consistently generate realized losses. These losses can be “banked” indefinitely, and used to offset harvested gains that are strategically timed and cancel one another out–the net result being $0 in tax.
Under reasonable assumptions, in this example a steady, conservative rebalancing would bring the single stock down to 42% of the investor’s portfolio in a decade–with the $20m portfolio ($16m in the single stock; $4m in a diversified portfolio) growing to $50.3m ($21m in the single stock; $29.3m in the diversified portfolio) assuming 10% annual appreciation.
Of course, this hypothetical investor could diversify over time without a tax strategy, sacrificing the benefits to avoid the costs. However, this likely produces significantly inferior results.
The exact same rebalancing example as above–without Ultra Tax Efficient Wealth ManagementSM (avoiding the assumed 0.9% in annual costs)–yields a $44.3 million portfolio ($21 million in the single stock; $23.3 million in the diversified portfolio) after a decade.
Compare these identical diversifying single stock sales over time and you’ll see the UTEWMSM strategy produces a more well-diversified portfolio that is $6 million larger after 10 years (after accounting for 0.6-0.9% in incremental annual costs and ignoring the incremental return the strategy is designed to provide).
When diversifying a concentrated stock portfolio, the benefits of Ultra Tax Efficient Wealth ManagementSM can be expected to greatly exceed the costs.
The graph above is an illustration of mathematical principles used to demonstrate the impact of taxes and compounding on returns. Returns and tax rates are not reflective of any actual or expected investment outcomes or tax rates. Actual results cannot be guaranteed and will vary.
SOURCE: HWM calculations (available upon request)
Further, these benefits compound over time: continuing the same approach and assumptions, the concentrated stock is completely sold after 18 years with no net realized capital gains–that is, no capital gains taxes paid.
At this point the investor in our example has a $102.6 million diversified portfolio using Ultra Tax Efficient Wealth ManagementSM, versus having a $78.3 million diversified portfolio without a tax strategy.
These results are as if the investor saved over $24 million in capital gains taxes over time!
The graph above is an illustration of mathematical principles used to demonstrate the impact of taxes and compounding on returns. Returns and tax rates are not reflective of any actual or expected investment outcomes or tax rates. Actual results cannot be guaranteed and will vary.
SOURCE: HWM calculations (available upon request)
Tax-Efficient Investing: A Smarter Path to Long-Term Wealth
Want to Minimize Investment Taxes? Learn More About Ultra Tax Efficient Wealth ManagementSM
Ultra Tax Efficient Wealth ManagementSM can also benefit diversified, highly-appreciated stock portfolios. While there are other strategies for accessing the value of an appreciated stock portfolio without generating a large tax bill (for example, borrowing against securities) none offer the efficacy of Ultra Tax Efficient Wealth ManagementSM–particularly at current interest rates.
Similarly, Ultra Tax Efficient Wealth ManagementSM can offer powerful tax reduction for other liquidity events such as selling either a business or highly appreciated real estate–financial events which, until now, have come with massive tax price tags attached to them.
Part of the UTEWMSM offer with Hendershott Wealth is that we’ll create custom analyses for your specific situation. As each of these situations call for custom planning, we are here to help you find the one that best fits your circumstances–and keeps your money in your accounts. Individualized tax management strategies, on the other hand, are necessary to take full advantage of the opportunities in different situations.
To find out if you’re a suitable client and get started on a custom proposal for Ultra Tax Efficient Wealth ManagementSM, get in touch.
At HWM, we’re happy to consult on how this powerful, tax-optimized approach that the super rich have been using to build wealth for nearly a decade can work in your situation.
Disclosures:
All investing involves risk, including the potential loss of principal. There is no guarantee that any investment plan or strategy will be successful. Advisory services provided by Hendershott Wealth Management, LLC (“HWM”), an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training.
All written content in this article is for information purposes only and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. Opinions expressed herein are solely those of HWM, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.
All examples in this document are strictly illustrations of mathematical principles, not actual or hypothetical returns. These illustrations have many inherent limitations, some of which, but not all are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there will likely be sharp differences between these illustrations and actual results subsequently realized by any particular trading program. Illustrations do not account for market volatility or the impact of financial risk that is experienced during actual trading.
The realized tax benefits associated with the tax-aware strategy may be less than expected or may not materialize due to the economic performance of the strategy, an investor’s particular circumstances, prospective or retroactive change in applicable tax law, and/or a successful challenge by the IRS. In the case of an IRS challenge, penalties may apply.
There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. When trading these instruments, one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives and using leverage. All funds committed to such a trading strategy should be purely risk capital.
Shares of appreciated assets cannot be restricted and must be unencumbered. Security must have a minimum market cap of $1B and be a constituent of the Russell 3000 Index.
Investment minimums apply. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.
