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Jean-Luc Bourdon
Jean-Luc Bourdon
 

An Investor’s Best Friend

CPAs can wield a powerful influence on net investment returns. Here’s why and how.

January 4, 2010
by Jean-Luc Bourdon, CPA, PFS

Investors face 2010 still shaken by the nerve-wracking events of the last two years. The Dow Jones Industrial Index dipped below 6,500; financial industry bail-outs cost billions; fallen investment stars and gigantic Ponzi schemes shook the foundation of trust in financial “experts.” Many Americans will begin the New Year resolving to find a trusted advisor to help bring their long-term investments back on track. Research points to an unlikely super-hero — a CPA.

Special Powers

Thornburg Investment Management’s Study of Real Real Returns (PDF) illustrates how taxes reduce an enormous portion of investment returns over decades. For example, about half the returns from an investment mirroring the performance of the S&P 500 index over 30 years would have vanished to fees and taxes. The latter, of course, is the primary culprit. The ability to reduce taxes on an investment portfolio therefore greatly enhances what an investor gets to enjoy in the long-run: net returns.

In the constant search for greater returns, many investors seek an investment manager who can beat the market. Certainly, some investment managers have a track record indicating that they are able to do this. Alas, a new study by professors Eugene Fama and Kenneth French concludes that it is impossible to tell if an actively managed fund beat the market out of luck or skill. Consequently, there is no reliable way to pick an investment whiz who can consistently deliver superior returns.

Respected research (PDF) indicates that the difference in returns between portfolios is explained almost entirely by asset allocation, while market timing and security selection play much smaller roles. In other words, the types of asset classes included in a portfolio and the proportions represented by each are the dominant determinants of investment returns. Without a doubt, the ability to identify a portfolio’s objectives, constraints and asset allocation mix, should not be underestimated.

However, in the absence of reliably outperforming investment managers, once an ideal asset allocation is identified for a particular investor, there is very little that can be done to dependably boost expected investment returns. Gross returns, that is! After-tax investment returns, on the other hand, can benefit greatly with the help of a tax specialist.

Ideally, investors could choose an investment manager who specialized in taxation — or, better yet, a tax expert who specialized in investments! The best of all possible scenarios would be a tax expert capable of coordinating the various elements of personal finance (such as tax, estate, investment, financial and protection planning). A CPA holding the Personal Financial Specialist (PFS) credential would certainly fit that job description. To find a PFS or become such an effective advisor, turn to the AICPA Personal Financial Planning Section.

Each January, hundreds of CPAs hone these special skills by attending the AICPA Advanced Personal Financial Planning (PFP) conference. There they share knowledge and experience on leveraging opportunities and avoiding pitfalls to benefit their clients’ overall personal finances. It is not too late to join the 2010 PFP conference or too early to plan to attend next year. If you are struggling with effectively integrating estate, risk management, retirement and investment planning into your tax practice, attend the all day pre-conference optional workshop From Tax Advisor to Wealth Manager: The Road Best Traveled. Members of the PFP Section receive $300 off of the regular price.

Special Tools

How can CPAs apply their expertise to the tax management of investment returns? Here is a broad overview of a few helpful tools:

  • Asset Location. When investors face the choice of locating assets in either taxable or tax-advantaged accounts, the decision can be complex and controversial, but always important. A solid knowledge of circumstances specific to the client (including taxation) is critical. For instance, an advisor may choose to place equities rather than fixed income in a particular client’s taxable account to:

    • Favor capital gains over ordinary income,
    • Plan for a step-up in basis for heirs,
    • Defer taxes with unrealized capital gains,
    • Get better opportunities for loss-harvesting with volatile assets,
    • Plan donations of appreciated assets or
    • Utilize a foreign tax credit.

The choice among tax-advantaged accounts itself is far reaching. For example, for the first time this year, many investors will have the opportunity to convert their traditional IRA to a Roth IRA. Here also, tax strategies based on an understanding of client-specific circumstances should guide the decisions. The AICPA’s PFP section offers its members many resources to plan for Roth conversions, including a FREE electronic copy of the forthcoming Bob Keebler book, The Rebirth of Roth: A CPA’s Ultimate Guide for Client Care.

  • Asset Selection. Taxes are a drag on the power of compounding growth. Minimizing short-term capital gains and deferring long-term capital gains unleashes more compounding force to work for investors. In the case of mutual funds, this can be pursued with funds that have low portfolio-turnover. Investors should consider the benefits of “tax-advantaged,” “tax-managed” or “core” mutual funds, as well as Exchange-Traded Funds (ETF). Before investing in a particular mutual fund, investors should assess the fund’s accumulated unrealized capital gains, which become the investor’s tax obligation when distributed.
  • Loss Harvesting. Tax loss harvesting is often considered a year-end activity. However, losses ripen year-round and should be evaluated regularly. For instance, the best opportunity to realize 2009 losses could have been last March, when the Dow Jones Industrial Average (DJIA) dropped to a closing low of 6,547. Furthermore, waiting until year-end may cause a loss to become a long-term capital loss, which could be less valuable than a short-term loss. To keep the benefits of loss harvesting, tax rules for “wash sales” must be clearly understood. Here also, such benefits should be evaluated within the context of a client’s entire state of affairs. For example, the benefits of portfolio losses might extend to the sale of collectibles or real-estate property.

Conclusion

These tools illustrate that investment tax-management is technical, complex, client-specific and ripe with opportunities for the tax expert. Coupled with the lack of reliability inherent in investment management focused on outperforming the market, CPAs have a unique opportunity to be the most effective and dependable advisors in long-term financial planning.

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Jean-Luc Bourdon, CPA, PFS is a wealth manager with Walpole Financial Advisors, LLC (WFA) in Goleta, CA. His opinions and comments expressed within this column are his own, and may not accurately reflect those of WFA. This information is being provided for informational purposes only and does not constitute investment or tax advice. Nothing in these materials should be interpreted as implying the performance of any client accounts, or securities recommendations. Bourdon volunteers as financial literacy advocate. He also currently serves on the UW-Platteville’s Distance Learning Alumni Advisory Board. The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.