Business owners approaching retirement often have a large portion of their portfolio in taxable assets — often due to the sale of their business.
Although an ideal tax allocation depends largely on an investor’s unique situation, flexibility in optimizing retirement spending strategies usually depends on diversification between pre-tax, Roth, and taxable assets. One key difference between these three is how they are taxed.
Very generally speaking, distributions from pre-tax accounts are taxed as ordinary income, distributions from Roth accounts are tax-free, and taxable accounts are taxed at capital gains rates.
Separately Managed Accounts (SMAs) can give investors with large taxable accounts some unique advantages that are otherwise not available through mutual funds or exchange-traded funds (ETFs).
What Are SMAs?
SMAs are often described as an investor’s own personal mutual fund.
Rather than buying shares of a basket of stocks, an investor has an account with actual stock positions aimed at gaining exposure to some part of the market. This account is managed by a third party (usually a professional investment company).
For example, SPY is an index fund seeking to track the S&P 500. SPY has approximately 500 holdings. An investor could purchase a share of SPY and get exposure to the 500 holdings within the fund.
An SMA, however, would have actual stock holdings rather than shares of a fund. SMAs are taxable accounts. This means that you will receive a 1099 form at the end of the year, and income is reported on your tax return.
Tax Loss Harvesting and Managing Capital Gains
Mutual funds or ETFs can be limited when it comes to tax loss harvesting.
This is because while a share of a mutual fund might be down 10% year-to-date, the underlying stock positions in the fund might paint different stories. There could be, for example, a holding within the fund that is down 40%.
But the losses from this position can’t be harvested because it is inside the mutual fund.
With an SMA, you have the flexibility to reach into the account and harvest losses from individual stock positions. Even during times when the “market” is up, there are usually always companies that are underperforming in a fund.
This means that an investor can harvest losses throughout the year, even during different market conditions. But why is tax loss harvesting important? Losses can be carried forward from year to year, and those losses can be used to offset capital gains.
This same sort of logic can also be applied to charitably inclined investors. An investor with charitable giving goals can also benefit from SMA’s through gifting appreciated stock positions in-kind. Gifting appreciated stock eliminates the embedded capital gains while accomplishing their charitable giving goals.
The flexibility of SMAs means much more efficient and flexible giving strategies.
An SMA also gives an investor flexibility to optimize their account.
Mutual funds or ETFs might include companies that the investor does not want to own. With an SMA, the investor can elect to exclude certain companies that they don’t want in their portfolio. This customization is one of the most appealing aspects of SMAs for investors.
Mutual fund managers could rearrange portfolios in ways that might have drastic tax consequences for investors. Perhaps a fund tracks a certain index and must go through reconstitution each year.
Reconstitution usually occurs when the fund drifts from its target as stated in a prospectus. Companies may change in size or might go bankrupt, and the fund is forced to rearrange the portfolio to return to the desired structure — thus the word, reconstitution.
This might involve selling off positions, creating unexpected and even unwanted capital gains. This can be especially frustrating for investors because the taxable events are out of their control. Investors can skip this headache as SMAs allow for more flexible trading and aren’t bound by a prospectus.
Limitations of SMA’s
Probably the biggest setback of SMA’s is the high capital need.
Depending on the quality of the organization and investment philosophy, the minimum investment could be a few hundred thousand. Historically, those minimums have been as high as millions of dollars. SMA strategies are becoming more and more affordable for investors, although they still require some skin in the game.
Another possible setback to the SMA strategy deals with taxes. The relatively high minimum investment means that investors probably have some positions that have high unrealized capital gains. Moving out of mutual funds or ETFs and into an SMA strategy means that the investor will need to realize those capital gains.
This likely means paying thousands of dollars in capital gains taxes. Planning and preparation can help minimize tax liability, however. Tax-loss harvesting, for example, can help offset the gains from the transition into the SMA strategy. Investors can also slowly transition into the strategy to help spread the taxes over time.
Seeking Professional Help
If you are a retired business owner or an investor with a large portion of your portfolio in taxable assets, an SMA strategy could be beneficial for you.
Because SMAs are more complex in nature, investors should seriously consider working with financial advisors in Utah before pursuing a strategy that involves SMAs. A qualified financial professional can help investors understand the consequences — good or bad — of opening an SMA as it relates to their unique situation.
Contact TrueNorth Wealth, a leading investment company offering the best strategies for financial planning in Boise, ID, and throughout Utah, for a consultation!