Turning Tax Strategy On Its Head To Serve Wealthy Clients In High Income-Tax States Hot

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Steven M. Berman, a Mill Valley, California, financial advisor, in this guest post, explains when conventional tax strategy must be turned on its head to advise UHNWIs from high income-tax states. Berman, who provides tax-efficient portfolio advice to UHNWIs, explains an important exception to rules about locating investments in the right account, which was discussed at a recent webinar by Bob Keebler.  


You asked about why I differ differed with Bob Keebler’s remarks about where to typically locate client asset classes and choosing between taxable and tax deferred accounts. Bob recommended keeping the majority of one’s fixed income in tax-deferred accounts (IRAs, 401ks, and similar), as they throw off highly taxed income if located in taxable accounts. Here goes: If ones client base typically involves the proverbial one percenters — those subject to the highest tax brackets (state and federal) then Bobs general (good) advice should, in my opinion, be turned on its head.

My typical client is definitely a member of this club
, which leads me to different conclusions than Bobs initial analysis. Californians earning over $1MM/year are exposed to the 39.6% federal bracket, the 3.8% Medicare tax, Pease (phase out of itemized deductions), PEP (phase out of personal exemptions), and a California income-tax rate of 12.3% (reduced by the 39.6% state-income tax deduction).

The marginal tax rate can easily be at least 52% or more for a married California resident with taxable income between ~ $457k to $1MM!

It is similar for NY (especially NYC), MA, HI, and other citizens of states with high state income tax rates. As I have clients in each of these states
, this is not a theoretical or trivial matter. It is something that can be analyzed and dealt with, such that my clients receive real financial benefits from using the best asset class location strategies for placement of their fixed income.

For example, currently
, the Vanguard CA Intermediate Term Muni Bond Fund, Admiral Class (VCADX), yields ~ 1.57% with a duration of ~ 4.95 years. This is a fund I use for almost all of my CA clients. All yields are 30-day SEC yields and valuations are based on 3/17/2015 pricing. It is fully tax-exempt for the California taxpayer at the state and federal level. The taxable equivalent yield for this fund would be (1.57% / (1-.52)) = 3.27%.

The Vanguard Total Bond Market Index - Admiral Class (VBLTX) yields ~ 2.06% with a duration of ~5.6 years
, which makes it ~ 10% more exposed to interest rate risks than VCADX (with its 4.95-year duration). It is a blend of all types of taxable bonds, including treasuries, agencies, and high-quality corporate bonds, making it a highly diversified fixed-income holding. Similar to the Barclays Aggregate Bond Index, which is used as a fixed income benchmark.

If one wants to concentrate exposure to a specific sector of the fixed income market — like VCADX
, which, of course, is concentrated in the CA muni bond sector — the Vanguard Intermediate-Term Investment Grade Bond Fund, Admiral Class (VFIDX), is an excellent choice, one that I actually typically employ for intermediate-term fixed-income exposure in client tax-deferred accounts (only) when there is no more room in a clients taxable account for muni bonds. It sports a 2.54% yield with an average duration of ~ 5.24 years – again very similar to VCADX, but even a bit more exposed to interest rate risk than VCADX.

So, for a client with ~ $1MM intermediate-term fixed income asset class asset allocation, the extra-annual income derived from using the proper asset location strategy for fixed income becomes (3.27%
- 2.54%) * $1MM =) $7,300/year. This assumes using VCADX versus VFIDX. It would be substantially greater if one used VBLTX, adding ~ $12,100/year. These values are basically “free money” for the client. And I have numerous clients in this situation that earn substantially more than this every year by using better fixed-income asset location strategies, tailored to their specific tax situations.

Other benefits of this asset location approach
, especially for those of us who routinely rebalance client portfolios, as I do, on a weekly basis, is that it tends to push equities into tax-deferred accounts. When rebalancing, opportunities are available and equity asset class assets are, thus, sold (as part of the rebalancing process). No taxable events are created in client rebalancing when the sells are made in-tax deferred accounts.

Of course, everything I do is client-specific. So there are situations when it is best NOT to use this asset location approach. If
, for example, I am working with an elderly client with an actuarially short-life expectancy and taxable account assets and who would receive a full step-up in basis upon their demise, I would typically maximize fixed-income exposure to tax deferred accounts.

However, when a client has a potential long time horizon
, letting the higher-growth-equities grow unhindered by annual tax drag in tax-deferred accounts can make a valuable difference in client terminal wealth values. With a long enough time horizon, the higher tax-deferred equity growth — even when tempered by the higher taxes upon harvesting from tax-deferred accounts can trump equity growth in taxable accounts, even when subject to its eventual lower long-term capital gain rates upon liquidation.

This last point becomes even more important and powerful because our clients with high salary-income currently and in the highest marginal tax rates, may be subject to substantially lower tax rates in retirement when they begin to harvest from their tax deferred retirement accounts. Again
, there are so many moving parts to these types of decisions, and rules of thumb can be dangerous if not examined carefully. That is why there’s value in having an advisor help our clients succeed financially. 

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