It’s a perennial mantra from the wealth management industry: “Don’t let the tax tail wag the investment dog.” But as tax hikes loom under the Biden administration, it may be time to stop uncritically repeating the decades-old command.
The conventional wisdom cautions investors not to let their worries about the taxes they would owe in the short term drive their big-picture financial strategy long term. While it seems simple, it can refer to different scenarios, such as not selling an investment that has turned risky just to avoid a one-time capital gains bill. Or cashing in on appreciated stocks, bonds or funds before rates rise. Or not rebalancing a portfolio to spread out risks across more diversified investments, because doing so would trigger capital gains taxes on profits.
A mainstay among many financial planners, the adage has proven tenacious in the era of holistic financial planning, in which taxes are one piece of a larger investment puzzle for individual clients that includes estate planning, paying for college and home buying, among other goals. “When you only focus or laser in on tax strategy, it often seems to become a little too much just about money,” says the website of Wealth Impact Partners, an advisory firm in Needham, Massachusetts. “It’s about more than money. It’s about what matters to you.”
But some financial advisors say the maxim’s fundamental premise may be flawed, at least partially.
“It suggests ignoring taxes, but those are real costs,” said David McGranahan, an advisor and partner at Relative Value Partners, a $1.6 billion wealth management firm in Northbrook, Illinois. ”Most people who blanket say it are saying, ‘just make good investment decisions and ignore the tax considerations,’ and you just can’t do that.”
The test of the precept comes as many advisors rush to make tax-saving moves for their clients amid the House of Representatives approval on Nov. 19 of a $2 trillion bill of spending and tax increases. In that sense, advisors are deliberately nudging their clients’ tax tails to wag — or at least swish — their investment dogs.
“Advisors in general are much more tax-aware now than they’ve ever been,” said Tim Steffen, the director of tax planning at Robert W. Baird, a wealth and asset management firm in Milwaukee with more than $350 billion in client assets as of December 2020. “While we always caution against being too focused on taxes — don’t let the tax tail wag the dog — it’s important to always be tax-aware.”
The Build Back Better bill would raise the long-term capital gains rate on investments sold after two years and qualified dividends to 28.8% from 23.8%. It would impose a 5% levy on individuals making more than $10 million and 8% on those earning more than $25 million. It also ends so-called outsize retirement plans, including so-called mega Roth IRAs, by capping them at $10 million, and expands the 3.8% net investment income tax on single filers making more than $400,000 ($500,000 for couples).
Last but not least, it would raise the current $10,000 cap on the federal deduction for state and local taxes (SALT), which include property levies, to $80,000 through 2030. The polarizing legislation will likely undergo changes in the Senate, especially on the SALT provision, if it is to get a thumbs up from all 50 Democrats in that chamber as needed to pass and head to President Joe Biden’s desk for signature into law.
The canine-themed command has been around since at least the mid-1960s, according to Barry Popik, an etymologist and contributor to the Oxford English Dictionary. In 1965, a lawyer in Wisconsin was quoted in a newspaper article about a bank conference as saying that “One should not let the tax tail wag the whole dog. One should decide where and how he wants his money to go and then let his attorney or accountant handle the tax question.” Since then, the dictum has acquired its meaning of not letting fears of paying taxes sooner rather than later be the sole or dominant factor when making an investment.
Some advisors find it curious that the nugget persists amid the rise of tax-advantaged investing strategies.
Think of tax-loss harvesting, when an investor sells a stock, fund or other investment that has declined and reinvests the proceeds in another asset. The investor uses the capital loss from the sale to offset taxable gains on other investments. Losses can reduce taxable capital gains and offset up to $3,000 of ordinary income.
McGranahan said the tax-tail advice had staying power because many ordinary investors “don’t really do the math.” For tax-loss harvesting to be profitable, he said, the second investment has to rise enough to include the amount of tax paid on the first investment. “An advisor says, ‘that was a good decision,’ but that’s only a good thing if it outperforms beyond the taxes that the client had to pay,” he added.
Or think of the explosive growth in popularity of exchange traded funds that passively mirror an index. Many studies have shown that the after-tax returns of actively managed stock funds almost always lag those of ETFs. A 2016 Morningstar report found that “very few” U.S. equity funds with managers who pick their holdings outperform Vanguard index funds that serve as the manager’s benchmark. In a March 2020 note, Alex Bryan, Morningstar’s director of passive strategies for North America, wrote that “Tax efficiency is a hallmark of the ETF structure.”
Consider also what Wall Street calls “tax alpha.” The phrase refers to the extra profits that come on top of ordinary market returns due to tax-minimization strategies. It’s the opposite of “tax drag” — the amount by which cashed out profits are reduced after taxes are paid.
Spreading out a portfolio across stocks, bonds, cash and alternative investments, along with choosing winners, do the most to fuel pre-tax returns. But it’s what remains after the taxes that counts. While asset allocation and product selection are “the primary drivers of investment results on a pretax basis,” after-tax results “can vary greatly depending on the tax treatment of those investment decisions,” wrote Morgan Stanley in a May 2020 note.
McGranahan said that the conventional tax-tail nugget “doesn’t completely hold” and compared it to a quip and cliche. Dollars an investor has to pay to the IRS, he added, “are real and have to be considered with every investment decision you make.”