Tax Day is coming

Do you feel the pressure? More than half of total federal revenue is collectively paid by individuals through the Form 1040. Though other sources (corporations, payroll taxes, excise taxes, etc.) play a role, the bulk of the responsibility falls on us. Given upcoming 1040 deadlines, below I look at seven common tax-investing myths I often hear from advisors.

Myth #1: Focusing solely on pre-tax returns is sufficient.

Reality: Your clients can’t eat pre-tax return. Neglecting to discuss after-tax post-liquidation returns is akin to creating a family budget based on pre-tax income. No one would do that. Advisors need to know the different types of return to effectively guide clients:

• Pre-tax return
• After-tax pre-liquidation return
• After-tax post-liquidation return

At Frontier, we provide all three return types for our Tax-Managed Strategies, ensuring a more comprehensive understanding of investment performance.

Myth #2: Reported tax drag is the same for all my clients.

Reality: Unless your clients have more than $751,600⁽¹⁾ in taxable income, their tax drag (return lost to taxes) is likely less than reported by fund companies and many strategists. SEC guidelines mandate that all funds/ETFs publish after-tax returns using the highest tax rate in place.

The top income threshold was $464,850 back in 2015. The silver lining of the above-average trend in inflation has been the reasonably dramatic increases to the tax thresholds, as shown by the 61% increase from 2015 to 2025 for those paying the top tax rate.

At Frontier Asset Management, we provide our strategies’ After-Tax Return at both the top tax rates per SEC guidance and an assumed taxable income of $240,000. This gives advisors an idea of the range of after-tax outcomes. We believe this is important in two key ways: fostering better discussions with clients about achieving the goals for their taxable accounts and measuring Frontier on our value-add proposition of risk management and attractive after-tax returns.

Myth #3: Calculating taxes for Preferential Income is easy.

Reality: Determining taxes for Preferential Income, such as Long-Term Capital Gains (LTCGs), can be complex.

• To calculate the Preferential Income tax rate, you first need to determine Ordinary Income and account for various tax deductions from Gross Income.
• The table below illustrates the progression of tax rates for both Ordinary Income and Preferential Income. Note that these rates are based on Taxable Income, not Gross Income.

Consider the example of a married couple filing jointly with $630,000 in taxable income, consisting of:

• Ordinary income of $510,000 from combined W-2s
• Long-term capital gains of $120,000

Let’s examine how the $630,000 taxable income flows through the two schedules:

• Ordinary Income is taxed first, flowing through each tax bracket like a waterfall. In this case, the last $8,949 is taxed at a 35% rate. Only this portion of the Ordinary Income is subject to the 35% rate.
• Preferential Income, such as the $120,000 LTCG, starts where the Ordinary Income stops. Preferential Income stands on the shoulders of Ordinary Income.
• $90,050 of LTCG is taxed at 18.8%, while the remaining $29,950 is taxed at 23.8%⁽²⁾.
• As a result, the couple has two marginal tax rates: 35% for Ordinary Income and 23.8% for Preferential Income like LTCG.
• The overall effective (or average) tax rate is 22.5% (Total Taxes / Taxable Income), which is significantly lower than their top marginal rate of 35%.

Understanding the interplay between Ordinary Income and Preferential Income is essential for accurately calculating tax liabilities and making informed investment decisions.

Myth #4: Tax-loss harvesting is always fantastic. Give me more losses!

Reality: Tax-loss harvesting, while generally advantageous for taxable investors, is not a means to an end by itself. Taxpayers are able to deduct $3,000 of realized loss from taxable income, but for larger tax returns, this amount can often times be small in materiality. Beyond the $3,000 loss deduction, it is important to remember that a harvested loss needs a gain to offset. And when you tax-loss harvest, what do you do with the proceeds?

• Will you hold cash as you wait on what to do next, risking missed market opportunities?

• Do you have a higher confidence investment to replace what you sold? If you still have confidence in the security, how will you navigate the wash sale rules?

At Frontier Asset Management, loss harvesting is an opportunity to re-position the portfolio and to actively manage risk going forward. The created tax asset (realized capital loss) is an additional benefit for the investor.

Myth #5: IRAs are non-taxable. Advisors don’t need to worry about taxes.

Reality: Don’t forget the tax impact of Required Minimum Distributions (RMDs) on your clients’ overall tax situations.

• We see lots of cases where the size of the RMDs pushes clients into very high tax brackets. It is essential to strategize how to handle the after-tax proceeds effectively.
• According to the Investment Company Institute⁽³⁾, a significant 36% of IRA withdrawals are reinvested or saved into another account. To make the most of these reinvestments, employ a tax-efficient investment process that minimizes additional tax burdens.

At Frontier Asset Management, we assist clients in navigating the complexities of RMDs and offer guidance on managing the after-tax proceeds with a tax-smart investment approach. By addressing the tax implications of IRAs, advisors can help clients maintain a more favorable tax situation while optimizing their retirement savings.

Myth #6: Only use municipal bonds for fixed income in taxable accounts.

Reality: While municipal bonds are attractive for their federal tax-exempt interest income, they may not always be the only choice for fixed income in taxable accounts. The goal should be to maximize after-tax returns, not merely minimize taxes.

Consider these factors when evaluating municipal bonds:

1. Yield comparison: At times, taxable bonds may offer higher returns, even after accounting for taxes. Yields vary daily by sector, issuer, maturity, duration, convexity, etc. Bonds are hard. Active managers can -at times – find competitive and more attractive yields.
2. Risk management: Incorporating both taxable and tax-exempt bonds can help diversify fixed-income investments, reducing the concentration risk associated with relying solely on municipal bonds.
3. Marginal tax rate: As mentioned in Myth #2, published tax-equivalent yields generally assume the highest tax rate, so it’s essential to know your clients’ marginal tax rates for unearned income and calculate after-tax yields accordingly. Your clients’ after-tax yield for municipals may be different (lower) than what is reported.

At Frontier Asset Management, we believe in taking a comprehensive approach to fixed-income investments in taxable accounts. By carefully assessing market conditions, our active management strategies can uncover competitive yields and manage risk for our clients.

Myth #7: Direct Indexing is tax alchemy.

Reality: Since we do not have an exact product offering in this space, we are a quasi-objective party. We acknowledge the attractive features of Direct Indexing, especially for UHNW investors with specific needs. But it’s not tax magic.

Consider these factors when evaluating Direct Indexing:

• Scope of tax overlay: Is the tax overlay over the entire portfolio or just a single sleeve of the portfolio? More is generally better than part when it comes to tax overlay.
• Incremental cash flows: Will the portfolio have incremental cash flows? If not, how long until the account becomes essentially locked up?
• Fee and tax implications: At some point, it is possible the investor is paying higher fees for an account that is effectively passive because most of the large holdings have appreciated, and any active management would possibly trigger a tax.

Alignment with investment goals: See Myth #4 above; loss harvesting alone is not going to solve all tax problems. Understand the investor’s objectives and priorities. Concentrating solely on minimizing current taxes may not necessarily help them achieve their long-term financial aspirations.

Putting it together

Taxable accounts remain one of the areas where good advisors can add meaningful value on behalf of their clients. Understanding how and when your clients plan to use their taxable assets is key. Knowing their current marginal tax rates and where those rates may be in the next several years is equally (or more) important. Defining success by only minimizing taxes today may not help them achieve their life goals for their hard-earned investments. Don’t let the tax tail wag the dog.

⁽¹⁾Assumes a tax filing status of Married Filing Jointly (MFJ).  If filing status = Single, the required taxable income is $626,350.

⁽²⁾23.8% for top tax rate on preferential income = 20% + 3.8% for the Net Investment Income Tax (NIIT) which is applied to Modified Adjusted Gross Income > $250,000 (MFJ). Info assumes there is no unearned income characterized as Ordinary Income. If present, add 3.8% to unearned income greater than $250,000

⁽³⁾Investment Company Institute: IRA Owners Survey, ICI Research Perspective, “The Role of IRA’s in US Households’ Saving for Retirement, 2022.”