Envestnet Whitepapers

4 20241217-4105197 All these products can be placed within a UMA, illuminating why this account structure is almost essential to using an overlay properly. The overlay will not be equally effective in managing these products, though. This is why sleeve structure and asset location matter, too. For example, fixed income securities typically cannot be effectively tax-managed by an overlay manager. In addition, the ability to loss harvest fixed income securities can be very dependent on the market environment, making ongoing loss harvesting inconsistent. Also, if the investor is investing in taxable fixed income securities, which are less tax-efficient, they may want to consider holding them in a tax-deferred account like an IRA. Although mutual funds and ETFs are valuable as diversifying sleeves, equity SMAs should be used whenever possible, as they provide far greater tax management flexibility. Having a thoughtful approach to both asset location and sleeve selection that considers issues like these can influence how best to utilize the tax overlay and implement it effectively. Most importantly, it can lead to better after-tax outcomes for the client. Finally, tax overlay implementation should consider the potential sources of alpha in a taxable portfolio. We believe these sources are: • Security selection • Sector allocation • Factor exposures • Tax management Tax alpha is not widely recognized in the traditional financial literature, but that does not mean it should be ignored by industry practitioners. As the other three sources of possible alpha above can be ephemeral or expensive to reach, tax alpha may become more important for investors and their advisors. It can be integral to holistic portfolio management for minimizing tax liabilities and maximizing after-tax returns. This trend toward holistic portfolio management will likely accelerate in the future, too. Because ultimately, after-tax returns matter more than pre-tax returns. An effective tax overlay can often add more after-tax value than the other three sources of alpha combined, especially in asset classes (like large cap core) where it is exceedingly difficult for active managers to beat their benchmarks. Tax Overlay Concerns Due to the complexity of tax management for HNW portfolios, the use of an overlay may lead to questions and concerns. To proactively address three key potential obstacles or worries related to utilizing a holistic tax overlay, we'll provide some helpful tips and ideas. While we can't address every possible issue in this paper, our team is always happy to answer additional questions not covered below. Why Harvest Losses for Tax Purposes Now Without Gains to Offset? According to the Internal Revenue Service, "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss. If your net capital loss is more than this limit, you can carry the loss forward to later years." 2 This rule means that capital losses are valuable even when they are not immediately needed to offset capital gains from the same year. Losses harvested this year can be "banked" to reduce future taxes. An overlay that harvests losses in a year without capital gains is still useful. Although these losses are useful, the investor needs to understand that the usefulness is not "free." Aggressive loss harvesting introduces risk to the portfolio, resets the cost basis downward, reduces portfolio management flexibility, and can lead to portfolio lock. Product Type Suitability for Tax Overlay Typical Number of Model Holdings Index-based Equity SMA Very High Very High (100+) Actively-managed Equity SMA High High (30-60) Strategic, Diversified FSP Moderate Moderate (10-20) Style focused FSP Low Low (5-10) Tactical FSP Very Low Very Low (1-10) Individual Mutual Fund/ETF Sleeves Very Low Very Low (1) Bond Sleeves, Advisor Sleeves, etc None N/A 2: Internal Revenue Service. 2024. Topic no. 409, Capital gains and losses. https://www.irs.gov/taxtopics/tc409

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