Help your clients with 5 tax planning tips

December 29, 2016

Garrett Harbron

Garrett Harbron

For advisors, year-end meetings come with the prospect of telling clients they may need to pay some unexpected taxes.

To help clients minimize their tax burden, Garrett Harbron, CFA, CFP®, of Vanguard Investment Strategy Group offered five tax planning tips:

  • Location, location, location. Many clients are surprised when a mutual fund or ETF issues capital gains at year-end. Because of the rules that govern collective funds, capital gains distributions can occur even for tax-efficient investments such as index funds and ETFs. Some clients may even overreact and consider selling a position, which ironically could incur even more capital gains.

    Harbron said the best way for an advisor to help clients manage capital gains and investment income is through proper asset location. "Tax-aware advising starts there, choosing the best place to hold investment vehicles," Harbron said. "Advisors can add significant net returns to clients if they simply make a practice of holding the least tax-efficient investments in tax-advantaged accounts."

    The allocation chart below shows how advisors may help clients improve tax efficiency:
Investments more suited for:

Taxable accounts

  • Most broad-market stock index funds and ETFs
  • Tax-managed funds or other tax-efficient active funds
  • Municipal bonds
  • Individual stocks, if held long term

Tax-advantaged accounts

  • Most actively managed funds
  • Taxable bonds
  • REITs
  • Certain commodities, such as gold and silver ETFs
  • Individual stocks, if held short term
  • Some narrowly focused equity index funds and ETFs

Also, if clients pay capital gains from funds or ETFs in taxable accounts, they should realize their cost basis will increase, thus reducing capital gains if they later sell the position, Harbron said.

  • Consider a tax-efficient IRA withdrawal strategy. Most clients realize they will need to pay income taxes on money withdrawn from tax-deferred retirement plans or traditional IRAs. Many may not know that up to 85% of their Social Security benefits could be taxed as well, depending on their income.  A smart way to minimize those and other taxes in retirement can be by creating a source of tax-free income through the use of a Roth IRA conversion.

    Because taxes must be paid on the amount converted, the early years of retirement, before Social Security and Required Minimum Distributions start, can be an ideal time to convert. "Let's take an example of a client who has a pension and has some money in a taxable account," Harbron said. "If that client doesn't need to take Social Security and/or make withdrawals from his or her retirement plan or traditional IRA, his or her taxable income may be very low. Converting a traditional IRA to a Roth IRA when a client's tax bracket is low makes a lot of sense."
  • Be aware of year-end contribution deadlines. While clients typically have until April 15 of the following year to make IRA contributions (although there is a cost to waiting), this extended deadline doesn’t apply to many other tax-advantaged accounts. Employer-sponsored plans, such as 401(k) and 403(b) plans, as well as some 529 plans, require that contributions be made by December 31.

    While the contribution deadline for state tax benefits varies, annual federal gift tax exemptions are on a calendar year basis. Contributions to 529 plans count as taxable gifts, subject to the $14,000 per year per person per recipient gift tax exemption limit, meaning a married couple filing jointly could contribute up to $28,000 per year per recipient without incurring gift taxes. Also, 529 plans benefit from a special five-year rule, which allows clients to contribute up to five years' worth of gifts to a 529 plan, provided they make no additional gifts to the recipient during the five-year period. Since gift tax exemptions are on a calendar year basis, however, these gifts must be made by December 31 or they will apply to next year’s gift tax exemption.
  • Give to charities with tax-efficient contributions. Charitable donations don’t always have to be made in cash. It may make more sense for some clients to donate appreciated securities or property. If they donate securities or property, not only will they receive a full tax deduction for the fair-market value, but they will also avoid any capital gains taxes that would otherwise be incurred on the sale.

    Tax law limits the deductions for appreciated securities at 30% of a taxpayer's adjusted gross income (instead of the 50% limit that applies to cash), although contributions in excess of the limit can be carried forward for up to five years. However, the 30% limit doesn't apply if the client chooses to deduct their basis rather than the fair-market value.  

    High-net-worth clients and clients who may face a sudden windfall in income, such as a large bonus, may find a donor-advised fund particularly helpful. By donating to a donor-advised fund, clients can take the full deduction in the year the donation is made, then allocate the money to charities of their choice over time.

    Vanguard Charitable, a nonprofit organization founded by Vanguard, is a donor-advised fund.
  • Don't focus on taxes too much. While nobody likes to pay taxes, they are, after all, inevitable. While particular tax deductions or credits can be helpful, it is important for clients to remember that tax efficiency is not the only driver of returns.

    "Advisors and clients can get too caught up in the taxes, and if they're not careful, that can lead to the tax tail wagging the investment dog," Harbron said. "The most important aspect of investing is the asset allocation, that is, the percentage of the portfolio allocated between stocks and bonds."

    "If you need to give up some tax efficiency to make sure a client has the right asset allocation, then sacrifice the tax efficiency. Asset allocation is the main tool to control risk. If a client takes on too much risk and ends up selling at a market bottom, how tax-efficient they were makes little difference."

Advisors provide tangible value to their clients’ net portfolio returns over time through proper tax planning, and these year-end discussions are a perfect way to demonstrate that value, even beyond the advised portfolio, Harbron added.

"We will soon be at the point where an advisor can no longer realistically expect to charge 1 percent of assets and do nothing more than asset allocation and portfolio construction," Harbron said. "What we would say is: Automate as much of that as you can. Embrace technology, and use things such as model portfolios to do asset allocation. With the time you save, invest in tax planning, behavioral coaching and those things you can tailor to your clients' individual needs and circumstances."


  • All investing is subject to risk, including possible loss of principal.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
  • We recommend that you consult a tax or financial advisor about your individual situation.
  • Vanguard Charitable was founded by Vanguard as an independent, nonprofit organization. A majority of its trustees are independent of Vanguard. Although Vanguard provides certain investment management and administrative services to Vanguard Charitable through a service agreement, Vanguard Charitable is not a program or an activity of Vanguard.
  • CFA® is a registered trademark owned by CFA Institute.

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