Monday, 23 July 2018

The tax advantages of those who seek financial advice

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  • James Saft - June 2014

With tax season at hand, investors should consider one of the ways in which their financial advisors can earn their keep: tax advice.

Though diversification is sometimes called the only free lunch in investment, I’ve long thought that title better belongs to tax avoidance. The thing about tax savings is that they are real – a bird in hand – as opposed to gains from trying to outperform markets, which are by nature speculative.

To be sure, there is a legal limit to the gains that can be made by judicious application of the tax code. This is in contrast to the gains putatively available through speculation, which are theoretically infinite. This perhaps is why there are so many hedge fund managers on financial television and so few accountants. There is no Warren Buffett of tax-loss selling.

After all, the tax code, while complex, is certainly not rocket science and taking advantage of the quite above-board ways in which investors can minimize tax on investment gains is pretty much a matter of methodically placing one brick upon another.

Thus accountants, or their stand-ins in this case, tax-savvy investment advisors, do good service and are perhaps more likely to deliver what they promise than the would-be Buffetts of this world.

Gjergji Cici of William & Mary and Alexander Kempf and Christoph Sorhage of the University of Cologne published in February what they say is the first empirical study demonstrating that US investors get a genuine tax advantage by employing financial advisors.

“The tangible benefit we document appears in the form of useful tax-management advisory services to fund investors, which help them engage in tax-avoidance strategies,” the authors write. 

“Ruling out alternative explanations, we show that financial advice puts its beneficiaries, indirect channel investors, at a clear advantage over their peers who do not receive financial advice.“

Looking at a broad sample of US mutual fund flows from 1999–2011, the authors find that indirect investors, those who buy a fund through a broker or advisor, show a pattern of tax-avoidance trades about 64% stronger than those who own the same funds directly.

Limitations in the data prevent placing a dollar or annual return value on this pattern, but the authors consider and knock down a variety of other explanations as to why those who seek advice do better at avoiding tax.

A matter of timing

Much of this is really rather simple, but requires paying attention and taking the right steps at the right time.

For example, investors can avoid taxable fund distributions, which can incur tax, by either liquidating a position ahead of a taxable distribution bythe fund or postponing a purchase of that fund until after the taxable distribution has been made.

“Our results hold even after we control for the advisors’ compensation, fund performance, and several other factors that can affect flows,” according to the study.

The study also found evidence that advised investors did better at tax-loss selling, the selling of funds which have lost value in order to offset other planned or involuntary gains.

To be clear, we cannot know whether the tax avoided is equal to or greater than the fees or other compensation paid to advisors. Tax avoidance is, however, not the only way in which financial advice can be valuable. Remember too that taxes paid by mutual fund investors are significant, and have been estimated at more than 1% annually of assets, making them about as much a drag on returns as many active mutual fund management fees.

And, as those who seek financial advice have been documented by previous studies as being less financially sophisticated than those who don’t, the authors feel comfortable attributing the tax-avoiding behavior of those who do to the advice they get.

This study is far from the last word on the value of financial advice.Those who invest in index funds, for example, whether with or without an advisor, pay far less tax on distributions because index funds generally only sell when a security goes out of an index or if they face large redemptions by investors.

One other thing to remember is that the best way to avoid tax on investments comes with an unfortunate side-effect: death. That’s because financial holdings are re-based at death to their price then, rather than when originally bought.

Death and taxes are inevitable but, with help, we can hope to delay the first and minimize the second.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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