Separately Managed Account
Key Takeaways
• Direct indexing in an SMA allows for client specific customizations based on an investor’s personal values and tax profile.
• When funding a values-aligned portfolio with legacy holdings, selling appreciated securities that don’t align with the investor’s values criteria can trigger capital gains taxes.
• For investors with philanthropic intent, charitable giving may be a tool that can help transition the portfolio to values-alignment and further the investor’s values while supporting charitable causes and potentially reducing taxes.
When an investor funds the creation of a values-aligned portfolio with securities, one of the potential pain points is the tax hit associated with selling appreciated securities that don’t match the investor’s values criteria. Charitable gifting may be a tool that can help transition the portfolio to values-alignment and further the investor’s values while supporting charitable causes and reducing the donor’s overall tax burden.
The nexus between values-aligned investing and taxes
Values-aligned investors considering a direct indexing separately managed account work with their advisors to identify values criteria. These may include exclusions (think industries or company attributes the investor doesn’t want in the portfolio) and tilts (think attributes the investor would prefer be present or absent from the portfolio).
Since a direct indexing account can be funded with cash, existing securities, or both, the investor will want to think through the liquidity and tax considerations of this funding decision. Specifically, investors funding accounts with legacy securities may find that the values criteria they’ve selected indicate a need to sell an existing security which may have appreciated. Such a sale has tax implications, but the failure to sell may compromise the investor’s stated values.
Prior to funding an account with existing securities, an investor should assess the options and tradeoffs across values-alignment, tracking error, and taxes.
The benefits of donating stock
For those with philanthropic interests, charitable donations of stock may be used to transition a portfolio to values objectives while meeting charitable goals and potentially improving after-tax outcomes.
For example, donating long-term, highly appreciated stock may allow donors to support charitable causes while realizing several important income tax benefits: the donor may receive a fair market value charitable deduction1 and may reduce future capital gains. Such a strategy may also provide estate tax savings for wealthy donors.
Cash that might have otherwise been donated to charity may be used to replenish the account, maintaining the overall investment exposure while increasing the cost basis of the overall portfolio and potentially facilitating additional future loss harvesting opportunities. Furthermore, the addition of cash to legacy securities may make it easier to achieve any values-based portfolio tilts at a lower tracking error and/or lower tax cost associated with constructing the portfolio from legacy securities.
Assessing the options
Appreciated securities used to fund the account may run afoul of exclusionary criteria or have tilt scores that reduce their utility in tilting the portfolio toward a better average company. An investor has a series of options at this point, each with plusses and minuses. The table below summarizes some of these options and their potential tradeoffs.
Gifting is not only useful at portfolio inception Gifting is not only useful at portfolio inception
When there is a future values data refresh in which the status of a company changes regarding portfolio values criteria, rebalancing may be needed to maintain the portfolio’s values profile. If securities are sold to achieve this objective, capital gains may be incurred. Clients with charitable intent might instead choose to donate the affected securities to charity.
Customized SMAs Customized SMAs
One of the reasons direct indexing in an SMA is so powerful is that it allows for client specific customizations based on an investor’s personal values and tax situation. For clients with philanthropic interests, the ability to use charitable gifting as part of the portfolio construction process may further the client’s values, achieve charitable goals, help decrease forecast tracking error, reduce taxes incurred, and improve future tax-loss harvesting opportunities. Tax and financial advisors can help clients navigate these important considerations.
Aperio’s values-alignment strategists are available to answer your questions.
Frequently Asked Questions
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Donating appreciated stock may allow investors to reduce future capital gains while potentially receiving a charitable deduction based on fair market value, subject to applicable limitations.
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Investors can donate securities that do not match their values criteria rather than selling them and realizing taxable gains.
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A tax-aware transition seeks to move a portfolio toward a desired allocation while managing potential tax consequences based on the sensitivities of the client.
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In some situations, donating appreciated securities and replenishing the account with cash can increase the cost basis of the portfolio and enable future tax-loss harvesting opportunities.
Lincoln Fleming, CPA/PFS, CFP
Director and Senior After-Tax Wealth Strategist
Lincoln Fleming serves as a Director and Senior After-tax Wealth Strategist within SMA Solutions at Blackrock, where he helps taxable clients focus on the intersection of income taxes, investing, estate planning and charitable giving and to align investment decisions with their tax profile.
Mark Bateman
Managing Director and Aperio's Head of Values-Aligned Investing
Mark Bateman, Managing Director, serves as Aperio's head of Values-Aligned Investing. The Values-Aligned Investing team works extensively with Aperio clients to customize criteria that will best reflect their values or mission in their investment portfolios.
1In general, only appreciated securities held for longer than one year should be considered for donation. The deduction for short-term capital gain property is generally limited to basis. For donations of appreciated long-term capital gain property, the charitable income tax deduction may be limited to 30% or 20% of adjusted gross income (AGI), depending on the type of charity. For top bracket taxpayers, tax benefits of itemized deductions are capped at $0.35 per $1 deducted. Itemizing individuals can only claim a charitable deduction for contributions that exceed 0.5% of AGI.
Important Notes
Aperio Group, LLC, provides this material for informational purposes only and for the sole use of the recipient. The information contained herein was carefully compiled from both internal and external data, but we do not guarantee its accuracy. The information is provided with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in these areas. The strategies and/or investments referenced may not be suitable for all investors, because the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. None of the examples should be considered advice tailored to the needs of any specific investor or a recommendation to buy or sell any securities.
Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that any investment strategy discussed herein will work under all market conditions. Many factors affect performance, including changes in market conditions and interest rates, as well as other economic, political, or financial developments.
You should not assume that investment decisions we make in the future will be profitable or will equal the investment performance of the past. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. Past performance is not indicative of future results.
Any tax information provided herein is for illustrative purposes only and does not constitute the provision of tax advice by Aperio. Due to the complexity of tax law, not every single taxpayer will face the situations described herein exactly as calculated or stated, i.e., the examples and calculations are intended to be representative of some, but not all, taxpayers. Since each investor’s situation may be different in terms of income tax, estate tax, and asset allocation, there may be situations in which the calculations would not apply. Please discuss any individual situation with tax and investment advisors first before proceeding. For those clients using tax advantaged indexing, taxpayers paying lower tax rates than those assumed, or without taxable income, would earn smaller tax benefits from tax-advantaged indexing (or even none at all) compared to those described.
For values-aligned offerings, Aperio is dependent upon third=party data that may be incomplete, inaccurate, or unavailable. Aperio cannot guarantee the accuracy of the data disclosed by companies or the estimates made by third-party vendors when data are missing. Please see “Important notes” for details.
BlackRock does not provide tax advice. We urge you to consult with a tax professional regarding the potential tax consequences of this strategy.
Wash sale restrictions prevent investors from realizing a loss on a sale and buying a “substantially identical” security 30 days before and after the sale of the security. While “substantially identical” remains undefined, some tax practitioners suggest that investors ought to consider the degree to which the funds’ holdings may overlap and the degree of difference in prospective returns. The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer, and individuals must carefully evaluate their tax position before engaging in any tax strategy. BlackRock does not provide tax advice. We urge you to consult with your client and a tax professional regarding the potential consequences of this rule.
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