Is a Tax Management Overlay Right for Your Client?

Tax management is often integral to the advisory process as clients seek to reduce their liabilities while maximizing their after-tax returns. Employing a tax overlay strategy can help you achieve those goals for your clients. Overlay strategies are designed to produce tax-efficient portfolios that reflect an investor’s preferred asset allocation, risk tolerance and objectives.

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Tax Overlay Strategies for Financial Advisors

Tax overlay allows advisors to manage their clients’ tax exposure through a multi-pronged strategic approach. The overarching goal is to bolster clients’ after-tax returns, which is achieved using one or all of the following methods:

• Tax loss harvesting. Loss harvesting allows your clients to offset capital gains in their portfolios with capital losses. Harvesting losses is key when it comes to reducing taxation using an overlay strategy. It can also help you to set up your clients’ portfolios for long-term growth. For instance, if market volatility increases, that could create a buying opportunity for clients. You may sell off certain holdings at a loss while they buy in at the dip. This sets them up for growth once the market recovers.
• Periodic rebalancing. Tax loss harvesting and portfolio rebalancing often go hand in hand in an overlay strategy. Rebalancing ensures that client portfolios are aligned with their preferred asset allocation, based on their risk tolerance goals. As you rebalance, you may pair that technique with loss harvesting to minimize the client’s tax liability.
• Asset allocation vs. asset location. Asset allocation refers to the mix of assets your client holds, while asset location refers to where they’re kept. Both are significant in such a strategy. After all, your clients may hold certain investments that are more or less tax-efficient than others. An overlay approach requires you to consider where to place those assets (i.e., into qualified or non-qualified accounts) for maximum tax efficiency.  
• Tax-efficient investing. As you construct client portfolios using a tax overlay approach, investment selection matters. For example, does it make sense for your client to hold municipal bonds, taxable bonds or a mix of both? If you favor exchange-traded funds (ETFs) for diversification, which funds are most or least tax-efficient? If your client has assets held away, how does the tax profile of those assets influence your decision-making in portfolio construction? Those are just some examples of questions to consider as you select investments.

Introducing Tax Overlay Strategies to Your Clients

If you think your clients could benefit from tax overlay, the next step is determining how to implement it. Many advisors choose to coordinate with a tax overlay manager or provider to outsource this aspect of their practice.

Overlay managers coordinate with advisors and their clients to develop tax-optimized strategies for trading that consider risk tolerance and target allocations. Client portfolios are invested according to the parameters they set for risk and gains. Then, the overlay provider manages the account accordingly.

There are fees involved, but there are several benefits to outsourcing that can outweigh the cost:

• Scale. Offering tax management services can help you attract new clients and grow your business. For instance, you may be seeking to pivot toward high-net-worth clients as your core niche. Outsourcing can help you develop a new offering without being overwhelmed.
• Retention. Aside from attracting new clients, you may be in a stronger position to retain existing ones by introducing tax overlay services. Clients who appreciate the added value you offer may be more likely to stay loyal to you for the long term.
• Productivity. Attempting to handle the strategies outlined above can be time-consuming if you have a larger book of business. When you outsource, you can ensure that your client’s tax-management needs are being met without taking time away from other important tasks associated with running your business.

As you compare overlay providers, consider the scope of services offered, the fees you’ll pay and the level of support you can expect to receive.

How Tax Overlay Benefits Your Clients

Tax overlay offers numerous benefits to clients who need a well-planned approach to tax management. Here are some of the most significant selling points:

• Reduced tax exposure. The primary advantage of tax overlay is the potential to reduce tax liability for clients. You may be implementing some of the strategies, such as tax loss harvesting or rebalancing, but not all of them. By taking a comprehensive approach, you can ensure that your clients get to keep more of their wealth.
• Customization and control. Tax overlay strategies can be customized to fit each client you serve. Clients are also expected to offer their input during the planning process. If you’re offering overlay services through a manager or provider, your clients may have access to a secure portal or dashboard that allows them to track their portfolios in real-time.

Keep in mind that certain types of clients may be better served by tax-managed overlay than others.

If your client base is largely composed of investors with $500,000 or more held in taxable accounts with a substantial weighting toward equities, for instance, then a tax overlay could be an appropriate choice. Clients who are just getting started with wealth-building, on the other hand, may reap fewer benefits.

Frequently Asked Questions (FAQs)

What Is a Tax Overlay?

Tax overlay is a set of strategies designed to increase after-tax returns for investors while minimizing their tax liability. Tax management overlay considers a variety of factors that may impact a client’s tax outlook and investment returns over time.

What Type of Clients Benefit From Tax Overlay Services?

Clients who have significant assets in taxable accounts and/or hold a sizable amount of equities in their portfolio are typically good candidates for tax overlay. Many wealth management firms offer tax overlay services to high-net-worth and ultra-high-net-worth individuals to help them retain more of their wealth.

Who Is the Best Tax Overlay Manager?

Several companies offer such services to assist financial advisors in meeting the needs of their clients and growing their firms. Choosing the right manager to work with ultimately depends on several factors. For example, who your clients are, what they need in the realm of tax management and planning, and how much you’ll pay for overlay services.

Bottom Line

Tax overlay can be a valuable offering if you’d like to expand your services among your existing clients or attract new ones to your firm. Evaluating your clients’ needs is a helpful starting point in determining whether these strategies are something worth exploring.

Tips for Growing Your Advisory Business

• When investors need a financial advisor, many of them look to the web to find a professional to work with. Search engine optimization, social media and digital ads can help you attract new clients and increase your brand visibility. Working with an advisor marketing platform is another way to boost your firm’s profile. SmartAsset AMP (Advisor Marketing Platform) is a holistic marketing service that financial advisors can use for client lead generation and automated marketing. Sign up for a free demo to explore how SmartAsset AMP can help you expand your practice’s marketing operation. Get started today.
• If you’re not using a highly rated tax planning software in your practice, that could be a worthwhile addition to your tech stack. Tax planning software can assist you with scenario analysis, risk management and estate planning.

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