What Is Tax Economics?
Q&A with Aperio Cofounder, CEO, and Chief Tax Economist Patrick Geddes

Active Tax Management
May 17, 2017

Tax Economics is a mind-set and approach to making investment decisions focused on maximizing after-tax returns. Investors can reap enormous financial benefits by considering the tax implications of their asset allocations at the outset, rather than as an afterthought.

Q: Why is it important?

Investors are often paying more taxes than necessary. This is because most financial advisors are measured on pre-tax earnings and are not tax experts. And tax accountants often evaluate the tax implications of investments after the fact. This gap between investment expertise and tax expertise can lead to suboptimal investment decisions.

Q: Where does this methodology come from?

This strategy takes a page from corporate finance. Corporations include tax analysis as an integral part of their planning because it’s the after-tax cash flows that matter. However, that expertise hasn’t yet become widely available within the investment industry. Tax Economics gets left out because taxes are too often viewed as a variable that can’t be controlled, which is simply not true.

Q: Why is Tax Economics so often ignored?

Historically, taxable investors haven’t focused much on the impact of taxes, but they’re becoming much more sophisticated. Investment advisors can sometimes view an emphasis on after-tax returns with ambivalence, since the "sexiest" strategies can trigger the worst tax bills for their clients, even though those strategies are where the advisor may be perceived as adding the most value.

Q: How can advisors incorporate this approach?

Here are a few ways that Tax Economics can provide insights as advisors think about how they might help their investors maximize after-tax returns:

  • For most taxable investors, advisors should consider designing asset allocations that reflect an investor’s tax status. Investment advisors sometimes recommend the same portfolios for their taxable and tax-exempt clients, which by definition, may ignore the different needs with respect to taxability and its effect on the different investors’ portfolios.
  • Similarly, taxes can affect the best way to diversify concentrated stock holdings. For example, in a portfolio we analyzed recently, an advisor for a retired CEO faced the challenge of a heavy concentration in a single position, in this case a combination of common stock and nonqualified stock options. In this particular situation, our analysis showed that exercising the options rather than selling the stock would likely result in higher after-tax returns, which seems like a counterintuitive outcome. However, if the circumstances had been different, say the strike price on the options were much higher, then the resulting recommendation might have been different, or the tax treatment might have made no difference. The lesson here is that incorporating the tax impact rather than ignoring it can frequently improve a taxable investor’s outcome.
  • Optimize tax benefits of charitable donations. Investors often believe that they should generate additional income to get the tax benefit of a charitable donation. However, tax rules limit charitable deductions to a percentage of adjusted gross income, so most of the time generating more income actually makes the taxpayer worse off.
  • Understand the tax trade-offs of stock dividends.

Send questions or comments to blog@aperiogroup.com.

Due to the complexity of tax law, not every single taxpayer will face the situations described herein exactly as calculated or stated, i.e., the examples and calculations are intended to be representative of some but not all taxpayers. Since each investor’s situation may be different in terms of income tax, estate tax, and asset allocation, there may be situations in which the recommendations would not apply. Please discuss any individual situation with tax and investment advisors first before proceeding. Taxpayers paying lower tax rates than those assumed or without taxable income would earn smaller tax benefits from tax-advantaged indexing or even none at all compared to those described.


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