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"Compounding Erosion Is Driven by Tax Inefficiency"

By Holly SwanExecutive Director, Advisor Institute

How can you inspire clients to proactively look for opportunities to minimize and/or defer taxes to increase the benefits of compounding?

We turned to Natalie Miller, Director of Investment Strategy at Parametric to discuss how using her ism, "compounding erosion is driven by tax inefficiency," can help clients understand the benefits of tax deferral on their long-term tax outcomes.

Let's review the concept of compounding erosion and why clients should consider tax deferral to drive efficiency in their portfolios. According to Natalie:

"The economic impact of reduced taxes can grow over time—the potentially long-term compounding effect of tax deferral. When a portfolio is managed for taxes, more of the portfolio remains invested rather than going toward the payment of taxes, earning the portfolio a return. Instead of realizing a gain and paying taxes now on the sale of a security, delay the sale of the security to allow the tax dollars to remain in the portfolio with the opportunity to continue compounding. As more time passes, the impact of the tax deferral compounds. For investors who anticipate being subject to a lower tax bracket in the future, the value of deferral can be significant."

Let's assume you have a client whose long-term capital gains are potentially subject to a 25% tax. They're considering the sale of a security that would result in a $100,000 taxable gain. Here's one way that you could explain the benefits of tax deferral using Natalie's ism:

Client: "I'd like to sell my shares in XYZ stock."

Advisor: "Those shares have a very low cost basis. Have you considered the tax consequences of selling?"

Client: "Well, I've always believed that taxes are the cost of making money."

Advisor: "While that's sometimes true, it doesn't always need to be the case."

Client: "I'm all for lowering my taxes."

Advisor: "Since compounding erosion is driven by tax inefficiency, there's an important benefit to tax deferral."

Client: "What does that mean?"

Advisor: "If you sell now you'll have a tax liability of $25,000. By not selling and deferring that tax, that $25,000 would remain in your portfolio and can continue to grow alongside the rest of the portfolio."

Your clients are most likely aware of the power of compounding, yet they may be unaware of how taxes can decrease its benefits.

Bottom Line: Use an ism, such as "compounding erosion drives tax inefficiency," to help clients understand the benefits of tax deferral, and help you improve their after-tax outcomes over the long-term.