According to a recent study by Vanguard, financial advisors can add about 3% net return to clients’ portfolios; this is what Vanguard calls “advisor alpha.” Half of that return the investment advisor attributes to behavioral coaching (e.g., helping clients stay the course through market downturns). Approximately 95 basis points (bps) – close to what most firms charge to manage client assets – is due solely to advisors helping clients reduce the tax drag on their investments (i.e., via asset location and spending down assets efficiently).
Notably, these numbers are averages of estimates, and as the authors of the Vanguard study point out, there could be great variability in outcomes from one client to the next, and even one year to the next (e.g., the report shows a high end of 185 bps for investment tax planning). But what this study demonstrates is that nearly a third to a half of advisor alpha can be generated just from investment-related tax planning strategies alone!
So how can advisors capture as much of this tax alpha as possible for clients, particularly when those clients hold crypto assets? As we enter the 2022 tax season, below are some ideas that you can implement in your own practice.
1. Crypto is property for tax purposes
Per IRS Notice 2014-21, cryptocurrency is treated as property for tax purposes. This means that if an investor holds a crypto asset for over one year and exchanges it for another asset (crypto or otherwise), the investor would realize a long-term capital gain or loss. If the asset is sold after being held for one year or less, any gain on the sale is taxed at short-term rates, which is the taxpayer’s highest marginal tax rate.
One simple strategy to employ: hold crypto assets in a taxable account for over a year before selling them for a gain to take advantage of preferential tax rates (long-term capital gains tax rates are 0%, 15% or 20%, plus a net investment income tax of 3.8% might be applicable, depending on the taxpayer’s income). This strategy allows for tax gain (basis step up) or loss harvesting, which can add an appreciable amount of tax alpha.
Regarding tax loss harvesting, which is when an asset is sold at a price that is lower than its cost basis in order to offset realized capital gains elsewhere in the portfolio, there is a provision in the Internal Revenue Code that disallows an investor from recognizing a tax loss if a substantially identical security is purchased within 30 days of the asset sale. Instead, the repurchased stock or security retains the same cost basis as the asset that was sold originally. This provision is known as the wash sale rule.
Because crypto assets are deemed to be property and not securities for tax purposes, the wash sale rule does not apply. However, that could change since the 117th United States Congress would like to close this loophole.
Read more: US Crypto Tax Guide 2022
2. Asset location is crucial
Asset location is another extremely important aspect to consider when advising clients and can add a tremendous amount of tax alpha. Asset location is the concept of putting assets in specific types of accounts (i.e., tax-deferred, taxable and after-tax or tax-free) based on the tax attributes and expected growth of the asset.
For example, a bond (not a municipal bond though!) is best suited for a tax-deferred account because bonds generate interest income that is taxed at ordinary rates. While a growth-oriented stock or fund would be well-situated in a tax-free account such as a Roth individual retirement arrangement (IRA) because when the asset is sold and distributed from the account, no income taxes are incurred (though an additional 10% tax may apply if certain conditions are not met) by the taxpayer.
Here’s how asset location would come into play with crypto.
Let’s suppose your client is looking for yield and has parked money in a stablecoin and then lends the stablecoin out at an annual percentage yield of 8%. Ideally, the stablecoin would be held in a tax-deferred account because the interest income would be taxed at the client’s highest marginal tax rate if held in a taxable account, which is the same rate if a distribution is taken from the tax-deferred account. Effectively, the tax rates match, which is what you’re aiming for.
Now, let’s assume that your client wants to invest in bitcoin (BTC) and lend it out to generate some extra income. BTC has experienced tremendous – though highly volatile – growth over its lifetime. Some investors believe that it will continue to see significant price appreciation as compared to traditional assets. In this scenario, it might be a smart move for your client to invest in BTC using a self-directed Roth IRA and then lend the BTC out because there’s the growth play of the crypto coupled with the interest income generated from lending.
Read more: 4 Crypto Tax Myths You Need to Know
These are examples of some simple strategies that don’t require much tax acumen but can add a lot of value to your client’s bottom line, potentially even in excess of the fees you’re charging them. Investment tax planning is an integral component of advisor alpha, and whether the investments are stocks, bonds or crypto assets, the strategies can pretty much be universally applied.
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