Achieving Tax Alpha

At W1M we build portfolios that put the client at the centre of every decision. When it comes to an investment portfolio's performance, we focus on what really matters to clients most: money in their pocket. Where other investment managers may typically focus on achieving the highest gross return, we focus on achieving the highest return net of tax. How much tax an investor pays as a result of investment choices and location can dramatically erode the value they ultimately receive.

Tax Alpha refers to the additional value achieved by effectively managing tax as it arises on investments in client portfolios. At W1M we achieve this through various methods:

Asset location management

Different types of account structures and locations affect the tax treatment of the assets held within the account. For example, pension accounts are typically tax efficient and therefore the assets held inside these accounts give no rise to tax when they generate interest or are sold. Whereas General Investment Accounts (GIA) do not have tax efficient capabilities (allowances aside), so assets held in these accounts are subject to both capital gains tax and income tax. Furthermore, the specific owner of the accounts and their relative tax status can allow an opportunity for effective asset location management too where tax statuses differ in families.  

Tax Alpha can be actively pursued through location management by organising family assets amongst the different types of accounts and account holders to maximise the after-tax return for our clients. This can be achieved by investing in the higher tax burdensome assets, such as fixed income assets, in pension accounts and lower tax burdensome assets, such as growth equities, in taxable accounts.
We may also avoid investing in UK assets in accounts held offshore to the UK for certain clients to prevent the assets being captured in UK taxes.

Tax loss harvesting

When an asset is sold, if the price you receive is higher than what you initially paid for the asset a gain is realised, if the price is lower a loss is realised. Gains are typically subject to capital gains tax. For US people there is an added layer of tax for assets held for a shorter period of time: short- term capital gains and long-term capital gains.

We can actively pursue Tax Alpha in client portfolios by reducing this capital gains tax burden by netting gains that have been realised with strategic sells in assets that have losses. We often begin this planning towards the end of the tax year where we have a good idea of the gains that have been realised. We can then utilise losses where they have occurred to reduce this level of gain before the tax year end date. Reducing this tax burden maximises after tax return for clients.

Currency management

Investment managers tend to consider the gains or losses within client portfolios only in their local currencies; USD for US managers and GBP for UK based mangers. However, for international clients, this can often cause inadvertent tax implications when gains are assessed in the currency where the client is taxed.

To illustrate this, a security sold in USD may not have a taxable gain in USD terms, but when this is considered in GBP terms, currency movements may have caused a realisable taxable gain. These can apply to all forms of instruments, including cash, equities, fixed income and loans (including mortgages) that may have punitive phantom gains.

W1M consider the tax consequences across different currencies and jurisdictions to make informed investment decisions based on individual client circumstances. Once we have determined the tax position, we can use strategies including tax loss harvesting to achieve tax alpha.

Asset selection

An asset, which is subject to tax, is typically taxed as either income, dividend or capital gains. Understanding which of these rates is the lower rate for our clients and building portfolios intentionally to shift assets into this lower rate is an effect Tax Alpha strategy.

As an example, this can be effectively achieved with fixed income assets where there is both a component of capital gains and interest that makes up the total return. By specifically choosing assets where the larger part of the return comes from the capital gain and less of the return comes from the interest portion, we shift the tax burden of the asset towards the capital gains tax rates (e.g., 20% higher rate tax in US) versus income tax rates (e.g., 37% higher rate tax in US). You can read more about how these assets work here. 

Holding periods

US people have two layers of tax when it comes to capital gains tax: short-term capital gain tax and long-term capital gain tax.

When investing in assets, we select investments where our investment conviction is strong enough that we expect, in most cases, to hold the asset for at least a year. This shifts the tax due when the asset is sold into the lower long term tax rates (e.g., 20% higher rate tax in US) rather than the higher short term tax rate (e.g., 37% higher rate tax in US).

Utilizing tax wrappers

Both the US and UK offer tax-efficient savings vehicles. The main types are pensions, used for building a savings pot for retirement. In addition to workplace pensions, the UK offers Self-Invested Personal Pensions (SIPP), whilst the US has Individual Retirement Accounts (IRA) and Roth IRAs. These tax efficient wrappers enable the assets within to grow without arising income or capital gains taxes. SIPP and IRA contributions are made using untaxed money (with certain limits based on income), and distributions are taxed on withdrawal. The Roth IRA is funded using taxed income and the withdrawals are tax-free.

The UK also offers Individual Savings Accounts (ISA) with an annual limit of £20,000 per adult (or £9,000 for children). Like the Roth IRA, contributions are made after tax. For UK-only taxpayers, gains and income withing the ISA as well as withdrawals are tax free. For US taxpayers, the IRS looks through the wrapper, but whilst US tax rates remain lower than in the UK, having funds only subject to US tax represents a marginal benefit, which is compounded over a long period of time. There may also be an opportunity to use foreign tax credits to reduce the overall tax. 

We achieve tax alpha by working with clients to ensure they have utilised the tax benefits that these type of vehicles offer.

Where to spend from

When a client starts drawing from their portfolio, determining the priority order of different accounts to withdraw the funds from can be complicated, and even more so when considering taxable and non-taxable accounts held across the US and UK. We pursue tax alpha by looking at the withdrawal value required and pulling the funds from the most appropriate account and the most appropriate assets.

Whilst each client situation will differ, and tax advice may need to be sought, the typical order for spending will be as follows:

• General Investment Account (GIA)
• Individual Savings Account (ISA)
• Individual Retirement Account (IRA)
• Self-Invested Personal Pension (SIPP)

To read more about this, please click here.

Capital / income segregation

The UK taxes income and gains on an arising basis for all investments that are held in the UK, and globally for UK citizens residing in the UK. But there is also a beneficial system for US citizens (and other non-domiciled individuals) living in the UK, where income and gains derived from assets that are held outside the UK are taxed on the remittance basis of taxation for the first seven years, or up to 15 years if a remittance basis tax is paid. The rules therefore mean that UK tax is only levied if those gains are brought into the UK.

This, therefore, allows investment returns generated outside the UK to be segregated from the initial investment, and if organised correctly, not brought into the UK tax net.

The segregation of capital and income for US taxpayers can have a significant benefit, where the US typically has a lower marginal tax rate than the UK.

W1M use custodian banks that correctly manage and account for the segregation of capital and income. This enables the most tax-efficient remittance if assets are required to be brought into the UK for spending. This can have a significant impact on reducing the overall tax that an investor might have to pay and the money that is left in their pocket.