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IOVAs Present a New Take on Tax-Advantaged Investing

Taxes are top of mind for advisors and their clients. Not just during tax season — but all year long. 

Taxes rank consistently among investors’ top three financial concerns. Taxes also are the No. 1 financial concern of the ultra-high-net-worth, according to Jefferson National’s Advisor Authority study of more than 1,300 registered investment advisors, fee-based advisors and individual investors nationwide. Likewise, in our recent survey on the impact of Washington’s proposed policies, tax reform is the topic clients want to discuss most — almost twice as often as other policies such as trade, deregulation and infrastructure investment.

The single biggest investment expense your clients face? It could be taxes. Tax rates can be as high as 40 percent or even 50 percent, when federal and state taxes are combined. And with the market’s rise in 2016, many households could pay more in taxes. High earners and the high-net-worth are likely to be hit hardest. To minimize taxes paid on investment gains and income, it’s important to help clients achieve “tax diversification.” This means controlling for different tax rates, different types of taxes and when those taxes are paid.

Tax Deferral Helps Clients Keep More

Tax deferral is the key to helping clients keep more of what they earn during peak earning years, when they are taxed at a higher rate. They potentially can accumulate substantially more over time through tax-deferred compounded growth. And when withdrawing income in retirement years, they are likely to be in a lower bracket — and pay less in taxes.

The first step is investing in tax-deferred qualified plans. Yet the high earners and high-net-worth, who can easily max out the low contribution limits of individual retirement accounts and 401(k)s, have had limited options for accessing additional tax deferral. The challenge has been solved by a new category of investment-only variable annuities (IOVAs) designed specifically to maximize the power of tax deferral. With low fees, or even flat fees, no commissions, no surrender charges and an expanded lineup of underlying funds — including liquid alternative strategies like those favored by hedge funds — low-cost IOVAs are a tax-advantage investing solution with virtually no contribution limits.

There are many effective strategies to tax-optimize your clients’ portfolios using low-cost IOVAs with a broad lineup of funds, once qualified plans are maxed out.

Asset Location

Locating clients’ assets between taxable and tax-deferred vehicles based on tax-efficiency is a strategy known as asset location. Research shows that asset location could help increase returns by 100 basis points or more — without increasing risk. The tax savings and additional wealth created can be substantial, especially for clients in high tax brackets and those with portfolios of $1 million or more. Start by evaluating the tax efficiency of assets — those taxed at lower rates for long-term capital gains versus those taxed at higher rates for short-term capital gains and ordinary income.

Locate tax-efficient investments such as buy and hold equities, index funds, exchange traded funds, and tax-exempt muni bonds in taxable accounts. Locate tax-inefficient investments such as fixed income, real estate investment trusts, commodities, actively managed strategies and liquid alternatives in IOVAs, to preserve all of the upside without the drag of higher taxes.

Minimize Capital Gains Distributions

Experts say 2016 was one of the worst years for capital gains distributions on mutual funds. And that also could mean a bigger tax bill for your clients. When a fund generates income or has capital gains from selling its underlying holdings, it is required by law to pay investors distributions of the income and gain, minus the fund’s operating expenses.

Funds that trade actively and funds facing heavy redemptions are more likely to make substantial capital gains distributions. But when these funds are held in a tax-advantaged IOVA, distributions won’t be taxed and can be reinvested to compound and grow.

Tax-Efficient Rebalancing

Rebalancing helps return a portfolio to proper allocations by periodically selling assets that have gains and reinvesting in assets that have losses. When done in taxable accounts, your clients pay taxes on capital gains. But tax implications can be minimized through tax-efficient rebalancing. Take the total portfolio and divide it across a taxable account and a low-cost IOVA. When rebalancing means taking gains, do it inside the IOVA, where selling winners won’t generate a tax bill. When rebalancing means taking a loss, take it in taxable accounts and use it for tax-loss harvesting.

Unique Approach to Tax-Loss Harvesting

To create greater value for clients, harvest losses from their taxable account, then immediately buy those same categories of assets in an IOVA. It’s a little-known fact that by moving these assets into a tax-deferred vehicle, your clients can avoid wash- sale rules and still remain invested in the same asset classes. This allows clients to participate in future upside potential while cutting their tax bill to maximize future growth. Even over a short time horizon, the benefit can be meaningful for certain tax-inefficient assets and tactical strategies.

Preserving a Windfall

Many high-net-worth clients are likely to be entrepreneurs. When it’s time to sell their business, IOVAs are an effective tool to help optimize that windfall. After-tax profits from the sale can be used to build a diversified portfolio and invested in a low-cost IOVA, where those profits can grow tax-deferred. Depending on the client’s age and liquidity needs, locate the most tax-inefficient assets in the IOVA — or invest the entire amount.

Legacy Planning and Wealth Transfer

Trust income in excess of $11,950 is taxed at 39.6 percent — the highest income tax bracket — plus the 3.8 percent net investment income tax. By funding a trust with a low-cost IOVA, you can minimize, delay or even eliminate the current tax. This will maintain more wealth for the next generation of family members — and the next generation of clients for your firm.

IOVAs work well with many types of trusts: credit shelter trusts or bypass trusts to save more for future generations; net income with makeup charitable remainder unitrusts (NIMCRUTs) to reduce taxation of highly appreciated assets; revocable trusts to shelter income for clients in high tax brackets and special needs trusts. Or for a simple wealth transfer solution, use a nonqualified stretch with an IOVA to generate a lifetime income stream for heirs.

Tax-Diversified Withdrawal Strategy

One of the biggest challenges is how to draw retirement income so that clients don’t creep into a higher tax bracket unintentionally. It’s important to plan a tax-diversified withdrawal strategy by employing a range of income sources with different tax treatments. Diversify more strategically using Roth IRAs and traditional IRAs, fixed or immediate annuities, and systematic withdrawals from an IOVA. Nonqualified IOVAs are especially attractive because they have no minimum distribution requirements, offering tax-deferred accumulation beyond the age of 70½.

Creating a Personal Pension

Defined benefits plans and pensions continue disappearing. But wealthy clients can use low-cost IOVAs to create their own personal pensions. Grow these assets at market returns without the drag of taxes. Generate income at a later date as part of a tax-diversified withdrawal strategy, or annuitize when interest rates are more favorable. 

More Wealth for Clients — More AUM for Your Firm

Tax reform makes headlines because of the potential impact on every client, from the least affluent to the highest net worth. Yet history shows that tax reform comes and goes, a political poker chip leveraged by nearly every new administration. While taxes may be cut in the coming year, there are no guarantees — and current gridlock in Washington could create real roadblocks. Even if passed, these potential tax cuts could be short-lived if another administration takes office in four years.

When it comes to tax planning, there are many unknowns. While current tax policy is a known quantity, future tax policy is not and it is likely to change many times. Further, we have no idea what tax rates will be when clients retire. This ongoing cycle of change and uncertainty impacts clients’ ability to reach long-term goals.

So control what you can. Take a holistic approach to planning, keep costs low, and invest for greater tax-efficiency over the long term, including innovative IOVAs. The value proposition for using more tax deferral is simple and powerful. There’s a clear relationship between minimizing taxes and increasing returns without increasing risk. This means more wealth for your clients — and more assets under management for your firm.


Laurence Greenberg is president of Jefferson National, now operating as Nationwide’s advisory solutions business. He may be contacted at [email protected]

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