Quiz!
What are downsides of Separately Managed Accounts (SMAs) that are used to lower investment taxes? (There may be multiple current answers.)
- Extra risks.
- Extra costs.
- Higher taxes.
- Distraction from after-tax returns.
- Greater complexity.
- An eventual tax boomerang.
- Lower expected returns.
The Tax Bomb of Many Tax Strategies for Investments
There are many strategies that claim to avoid taxes on investments or greatly reduce them. Some have an obvious benefit without much of a downside. One example is Roth IRAs. Many more recent strategies come with a big catch: they don’t avoid taxes but only defer them, leading to a large future tax bill. This tax bill may come sooner than you expect as explained below.
What strategies have this catch? These are a collection of strategies that are typically housed in Separately Managed Accounts (SMAs). SMAs can be used to sell investments at losses to offset gains, creating an effect of lower (or no) investment taxes. A variant called direct indexing can start with an index and does the same to minimize taxes. Other variants go further with bets against investments using short positions or various derivatives. Some names are 130 / 30 (130% long + 30% short), and option overlay SMA (uses various derivatives to gain a short effect).
How is the tax bomb formed?
- Low basis, high gains: After a few years, the long positions end up with a very low basis and large unrealized gains and cannot be used to harvest losses.
- Lower returns: While you hold the strategy, there are many forces hurting the returns:
- There is an added annual cost to these strategies for the manager, plus financing cost for short leverage.
- The short positions and derivatives add risks. To manage the risk, portfolios often get tilted towards safer but lower-return allocations.
- Limited investments options, excluding the highest returning ones.
- The increased focus on taxes could create a distraction from maximizing after-tax returns.
- Over time, the portfolio holds increasingly overpriced stocks and gives up undervalued ones. This is the opposite of selling high and buying low.
- The tax bomb: After a few years (5 years according to product providers), the potential tax benefit diminishes so much, while the expected returns go so far down, that you would want to unwind these positions. Unless your goal is to never use the money on yourself (you hold till death or donate), you would have to pay the substantial built up tax.
Should you rule out all of these strategies in all cases? No. With the right set of circumstances these could make sense. Analyze the results over a full market cycle. This may require simulations given that many of these products existed for less than a cycle.
Conclusion: Be skeptical of tax strategies that promise to “eliminate” investment taxes. Often, they’re only postponing the pain, while lowering your returns in the process.
Quiz Answer:
What are downsides of Separately Managed Accounts (SMAs) that are used to lower investment taxes? (There may be multiple current answers.)
- Extra risks. [Correct Answer]
- Extra costs. [Correct Answer]
- Higher taxes.
- Distraction from after-tax returns. [Correct Answer]
- Greater complexity. [Correct Answer]
- An eventual tax boomerang. [Correct Answer]
- Lower expected returns. [Correct Answer]
Explanations:
- Without the extra focus on taxes, you can optimize for a combination of returns and diversification. The tax strategies can hurt both.
- These tax strategies typically involve extra costs.
- Taxes are expected to be lower, at least in the first few years.
- Given that higher returns often end up being taxed, the focus on taxes can distract from the ultimate goal, leading to lower after-tax returns.
- Tax strategies can add complexity in planning, implementation and tax reporting.
- The tax benefit can deplete within 5 years, with an allocation that targets much lower returns, leading to a big tax bill to unwind the unprofitable strategy.
- See #4.