As a financial advisor, determining the potential proceeds and tax liability resulting from selling a tax lot is critical to your client’s long-term success.
Intelligent Tax Optimization within Riskalyze Trading provides you with three tax management options for each account to: allow capital gains, avoid short-term capital gains, or avoid short and long-term capital gains so you can tailor your approach to meet the needs of your clients.
In this article
- Getting Started
- ITO in Action
- Setting a Capital Gains Maximum
To find the tax optimization options for a given trade list you’ll want to:
- Navigate to the trading dashboard and select the account you wish to review.
- Select the “Tax Management” Tab to view the ITO options.
Let’s see ITO in action:
Watch how you can become your client’s tax superhero in the video example below.
Note: We’ve included the same scenario shown in the video in text format below for those that would prefer to review an ITO example in written form.
Selling down a legacy position to fund the purchase of a model portfolio.
In this example, imagine a client ACATs in a large legacy holding of Apple stock (AAPL) with multiple tax lots and wants to sell a little over half of this AAPL holding to buy a diversified portfolio of ETFs. First, we’ll look at how ITO handles this situation, then we’ll compare ITO’s results to that of a rules-based rebalancing platform like Eclipse.
First, let’s look at the client's current position in AAPL.
You can see the client owns four tax lots of AAPL - all of them at a gain. Three of the tax lots are at a long-term capital gain (the client has held them for over 1 year), and one of the tax lots is at a short-term capital gain. So, given the fact we have 4 tax lots to choose from, and we need to sell around 800 shares of APPL, which lots do we sell?
After enabling Riskalyze Trading on this account, ITO recommends the following:
- sell all of the shares in tax lot 4 at a STCG.
- sell all of the shares in tax lot 3 at a LTCG.
- sell some of the shares in tax lot 2 at a LTCG.
We get a trade list telling us to sell a total of 792 shares of AAPL, resulting in $287,826 in long-term gains, and $4,019 in short-term gains. ITO is assuming the client pays 15% on long-term capital gains, and 30% on short-term gains. Some simple math((287,826*.15) + (4,019* .30)) shows us that processing these trades will add $44,384 to the client’s tax bill.
But how would a rules-based rebalancing platform handle this situation? A common “tax-efficient” approach taken by a rules-based solution is to sell tax lots in the following order:
- First, sell lots with short-term losses.
- Finally, sell lots with short-term gains.
Since the client’s current account has one tax lot at a short term gain, and three tax lots at a long-term gain, we can expect that a rules-based approach would do the following:
- Sell ALL of the shares in tax lot 3.
- Sell some of the shares in tax lot 2.
We can actually simulate this by forcing ITO into a “rules-based” approach, by choosing the “avoid short term capital gains” option.
And here’s the result, we get a trade list telling us to sell 792 shares of APPL resulting in a long-term gain of $296,852.
Some simple math (296,852*.15) shows us that processing these trades will add $44,527 to the client’s tax bill. Imagine how useful ITO is when working with an account that has hundreds or thousands of tax lots.
Using a rules-based depletion method (like FIFO, LIFO, or the example above) doesn’t always guarantee a trade list that creates the lowest possible tax liability. This problem is solved best by an optimizer that can run every possible combination of tax lots to sell, and then, after computing the actual cost to the client (by referencing their tax brackets), generates a trade list that incurs the lowest tax liability without compromising target accuracy. ITO also allows a “maximum capital gains” amount to be set, lowering the tax liability to the client.
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