Envestnet Whitepapers

2 20241217-4105197 Exploring tax overlays and their potential use cases Prepared by the PMC Overlay and Strategy Teams Introduction April 15th—Tax Day in America—often causes affluent and high net worth (HNW) investors to make major disbursements to the federal government. For individuals who make quarterly payments to the Internal Revenue Service, Tax Day rears its head in every season. Whether an investor endures the angst and, typically, cash outflow for federal taxes annually or quarterly, the individual's public equity portfolio is frequently the source of significant capital gains. The wealthiest 1% of households hold more of their wealth in stocks than in real estate and cash combined, 1 a situation that makes it especially important to assess the taxes associated with these large holdings. Due to caps on annual 401k and IRA contributions, it is also unlikely that wealthy investors have most of their equities in tax-deferred accounts. In this guide for financial advisors, we will explore how a holistic tax overlay may be used to manage equity portfolios in taxable accounts. Our examination will include a discussion of tax overlay implementation with a Unified Managed Account (UMA) and how these solutions can work together. We will also discuss tax alpha and its importance to affluent investors. Finally, we will consider a few possible challenges related to tax overlays and how to effectively navigate these concerns and complexities. In short, we will help you better understand how holistic tax overlays may make Tax Day less painful for your affluent clients. Holistic Tax Overlay, UMA, and Direct Indexing Defined Before we discuss the implementation of and possible use cases for a holistic tax overlay, we need to define exactly what it is. We also need to explain a UMA because, as we will see, this type of account provides a critical foundation for the tax overlay. This section will end with a word on direct indexing. It is time to dive in. Holistic Tax Overlay A holistic tax overlay is a discretionary, holistic tax management service applied to a client's investment account. It is typically implemented with clients who want to have significant exposure to multiple equity Separately Managed Account (SMA) sleeves within one UMA account. This tax overlay enables advisors and investors to address holistic needs around tax management while minimizing the effects that client specific customization requirements have on their investment portfolios. The overlay is intended to be applied to the entirety of an investor's taxable investable assets and managed portfolios and is tailored to individualized investor tax budgets and circumstances. Unified Managed Account (UMA) A UMA is a managed account structure that allows for many diverse types of investment products to be held in a single custodial account. Each investment product within a UMA is assigned its own "sleeve." The set of investment products and their target weights selected for the client's UMA is called the "UMA Target Allocation Model." In most cases, a UMA is traded by a centralized overlay manager to facilitate adherence to the client's target allocation and appropriate rebalancing activities. The efficacy of tax management does vary by sleeve type, though. Why is a UMA the preferable account type when offering holistic tax overlay services? A UMA provides a centralized overlay manager to coordinate taxable trades between multiple sleeves, allowing for taxes to be considered to be at the taxpayer level rather than at an individual investment strategy level. This level of coordination is unavailable outside of a UMA structure. Guide to Holistic Tax Management 1: Jones, John Bailey; and Neelakantan, Urvi. (November 2023) "Portfolios Across the U.S. Wealth Distribution." Federal Reserve Bank of Richmond Economic Brief, No. 23-39.

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