Tax Economics: think like a champion

The bottom line

• Tax economics is a framework for maximizing risk-adjusted after-tax returns.
• Ensure your asset allocation reflects your tax status.
• Investors should treat pretax returns like Grant Williams treated his contract offers.
• The only thing that matters is what you keep after taxes.

If you’re like me, your childhood dream was to one day be a professional athlete. I wanted to play in the NBA. My afternoons always ended with last second shots to win the big game. I imagined the sounds of the crowd. The celebrations with teammates. Gatorade showers. I did not, however, imagine a scenario where I am drafted by a perennial contender, make it to my second contract, and choose to sign with a different team. FOR THE SAME MONEY. Yet that is just what Grant Williams chose to do when he agreed to a sign-and-trade to the Mavericks this past summer. Why? Tax economics!

Tax economics is a framework for maximizing risk-adjusted after-tax returns. Unlike Grant, my after-tax compensation in the NBA was always going to be the same – ZERO. My professional hoops aspirations fizzled out in college. Jokes aside, taxes matter – especially for professional basketball players seeking to maximize their earning power. The Mavericks are based in Dallas, and Texas does not have a state income tax. Massachusetts, home of the Celtics, has a five percent income tax and an additional four percent excise tax on incomes above $1,000,000. As Williams put it: “[a $54M contract] in Boston, it’s really like $48 million with the millionaire’s tax.”¹ To match Dallas’s contract after factoring in taxes, Williams would have needed to earn closer to $58 million (by his math) – a meaningful difference.

So why am I writing about basketball? Because I love the sport, and it teaches us about tax economics. Investors should treat pretax returns like Grant Williams treated his contract offers. The only thing that matters is what you keep after taxes.²

How can you incorporate tax economics? First, ensure your asset allocation reflects your tax status. The same asset allocation designed for many well-known, tax-exempt endowments may ignore the varying needs of taxable investors.

If you are charitably inclined, optimize your charitable giving. Many high-net-worth investors donate cash to charity. A similar number are realizing net long-term capital gains. Yet, few investors elect to donate marketable securities to charity. Whether they are aware of it or not, investors are effectively liquidating appreciated securities, then paying taxes on those gains, and finally donating the smaller after-tax cash proceeds to charity. A better approach is to simply donate the appreciated security to charity and replenish the account with cash.³

Finally, for taxable investors, one of the biggest sources of tax drag in portfolios is capital gains triggered by manager activity in active strategies. While investors cannot control the decisions of active managers, they are not helpless against capital gains. One way to potentially help reduce tax drag in your portfolio is through active tax management strategies, like those offered by Aperio. These strategies typically aim to keep tracking error low, generate investment returns similar to those of an index fund (before taxes and fees) and, importantly, utilize systematic tax-loss harvesting to reduce taxes by reducing net capital gains on the client’s federal tax return.

Are you going to win an NBA championship next year? Probably not. Can you think like a champion? Absolutely. Anyone can use tax economics, and for a taxable investor, it’s highly encouraged!

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