Tax strategies for SMA investors to know

One of the primary tax advantages of separately managed accounts (SMAs) is their greater ability to engage in tax-loss harvesting. This involves strategically selling off some of the SMA’s underlying securities at a loss to offset gains elsewhere in the portfolio. By doing so, investors can potentially realize substantial tax savings. Notably, any capital losses that exceed gains can be carried forward indefinitely, allowing investors to offset gains in future tax years, providing a persistent tax benefit.

However, this effect can be limited in scope, particularly in a strong and sustained up market. In a bull market, investors may find themselves with a portfolio that has limited securities to sell at a loss. In this case, there are still several other tactics that SMA investors can employ to help manage their tax liability effectively. 

Making a difference through charitable giving

One strategy that investors can use to help reduce the current year’s tax liability is through charitable giving. By donating highly appreciated securities to charity, investors can receive a tax deduction based on the current market value of the securities, all while avoiding capital gains tax on the appreciation.

This approach allows investors to remove securities with large, unrealized capital gains from the portfolio without incurring a tax liability, while the fair market value of the donated shares can then be deducted from taxable income. At the same time, the charitable organization receives the full market value of the securities, maximizing the impact of the donation. This win-win situation serves as a powerful tool for both philanthropic efforts and strategic tax planning. As every financial situation is unique, SMA investors should consult with their tax advisor and a financial professional to help identify the best way to limit their tax liability.

Make sure you're effectively managing capital gains

If an investor has significant gains in a security, it’s often advantageous to hold this asset for more than a year so that the gains are classified as long term. Long-term capital gains are taxed at a lower rate, often significantly less than short-term gains, which are taxed as ordinary income. By waiting to sell securities until they’ve been held for more than a year, investors may receive substantial tax savings.

Additionally, investors should consider their current tax bracket when deciding when to realize gains. If an investor is in a lower tax bracket, it may be beneficial to realize gains now, as the tax impact will be lower. This strategy is particularly relevant for retirees or those experiencing a year of reduced income. Realizing gains during these times can be an effective way to help minimize tax liability.

Increasing the portfolio's tax basis

If it aligns with their asset allocation, investors can plan ahead and manage the portfolio’s tax basis by contributing additional cash to their SMA to purchase the underlying securities at a higher cost basis. By doing so, the investor will have greater flexibility when choosing individual security lots in the future, such as when trimming the position or harvesting losses in the future. Contributing additional cash can be a particularly useful strategy during market upswings when there are fewer opportunities for tax-loss harvesting within the current year.

Stay aware of any rules and regulations

While these tax strategies may offer significant benefits, investors must remain mindful of any regulations or considerations that may limit their ability to manage their tax liability. The wash sale rule is one such example, prohibiting investors from deducting a tax loss if a substantially identical security is purchased within 30 days before or after the sale.

This rule applies not only to the investor’s taxable accounts but also to transactions within tax-advantaged accounts like IRAs along with those owned by related parties. To fully leverage tax-loss harvesting opportunities, investors should ensure compliance with this rule to maintain eligibility for deducting any losses. 

Portfolio tax optimization is only one part of the picture

The end of the year provides SMA investors with a unique opportunity to optimize their portfolios and help minimize tax liabilities; however, tax efficiency shouldn't be the sole driver of investment decisions. Investors should remain focused on the broader picture, including their long-term investment goals, risk tolerance, and overall portfolio strategy. By keeping these considerations in mind, investors may navigate tax season more effectively and make informed decisions that align with their long-term financial goals. Please consult your tax or financial professional before making any investment decisions.