While many clients have budgets for vacations, home improvements, and charitable giving, not all clients have a tax budget. Yet tax budgets can be one of the most critical components of your practice.
Why tax budgets matter
By setting a limit on the amount of capital gains a client is willing to realize in a given year, this simple framework has the potential to:
- Improve portfolio tax efficiency
- Reduce year-end stress
- Increase client satisfaction
- Enhance long-term wealth building
If you haven’t talked to your clients about tax budgets yet, it’s a conversation worth having.
Making the invisible visible
Tax costs are everywhere in a portfolio, but they're largely invisible until April 15th rolls around. Unlike management fees that show up clearly on statements, or market losses that clients can see in real-time, the cost of tax drag operates in the shadows. Clients don't typically see the ongoing impact of poor tax timing, inefficient asset location, or accumulated short-term gains throughout the year.
Advisors can add value by making tax planning as visible and intentional as any other aspect of a client’s financial plan. When you introduce the concept of a tax budget, you're essentially putting a spotlight on this hidden cost and helping clients gain greater control over it.
Think about it like a spending budget. When clients set a vacation budget of $10,000, they make conscious decisions about flights, hotels, and activities to stay within that limit. A tax budget works the same way – once clients set a capital gains limit of $50,000 for the year, every portfolio decision gets viewed through that lens.
When done right, tax budgets can become as fundamental to wealth building as asset allocation or retirement planning.
The power of proactive tax planning for financial advisors
While the most obvious risk of operating without clear tax parameters is surprise tax bills, there are other risks as well. Without tax budgets, advisors may end up making reactive decisions at year-end. You might discover significant embedded gains in client portfolios when it's too late to offset them by harvesting losses. This reactive approach leaves money on the table and creates stress for everyone involved.
The impact compounds over time too. Clients who pay higher taxes early on have less capital for future investment, which hurts their long-term wealth building. And trying to manage tax outcomes manually across multiple clients can be difficult, even impossible. Along with the increased risk of mistakes is the risk of missed opportunities.
Clear tax budgets can help to reduce risk and increase efficiency through:
- Strategic timing: Delay a model change that triggers a capital gain in December until January to push gains into the next tax year and provide twelve months to harvest offsetting losses.
- Planning coordination: Align charitable giving, Roth conversions, or other tax-impactful decisions around the capital gains budget.
- Scalability: Use automated tax overlay services to manage individualized tax outcomes across all your client relationships.
How to build a tax budget as a financial advisor
So how do you get started setting a tax budget with your clients? Consider these three factors:
1. Set long-term capital gains limits
This is usually the easiest conversation. Many clients understand their income situation and can communicate how much in capital gains they're comfortable with based on their tax bracket and overall financial picture.
2. Establish your short-term capital gains philosophy
One way to help preserve clients’ returns is to establish a short-term capital gains budget of zero. For high-income clients, the tax difference between short-term and long-term treatment can exceed 25 percentage points. Few investment opportunities may justify paying double the tax rate.
3. Maximize tax planning flexibility
Consider "spending" the tax budget early in the year to get closer to your target model and help reduce portfolio risk. This approach can provide more flexibility for the remainder of the year and allow time for strategic adjustments.
Put tax planning into practice for your clients
Successfully implementing tax budgets requires the right conversations, clear expectations, and efficient processes. Here's how to put these concepts into practice.
Ask the right tax planning questions
It’s essential to get comfortable talking about a client’s tax situation. For example, you might ask:
- How do you feel about paying taxes on investment gains? What are your immediate and long-term goals for realizing capital gains?
- Are there any major financial or life events approaching that would affect how much you would be willing to pay in capital gains taxes next year? How much liquidity do you need this year?
- Would you prefer a large, one-time tax bill or smaller, recurring ones?
- What was your experience with capital gains last year?
Financial advisors might also consider asking clients if they can talk to the client's tax preparer to help align investment strategies with their annual tax planning.
Set tax budget expectations early
When onboarding new clients or accounts, it’s important to establish tax budgets for both the current year and future years. You’ll also want to make it clear that clients can change these parameters as their situation evolves.
For example, if immediately implementing your strategy would result in a huge, unexpected tax bill, you can offer the client a zero tax budget for this year and a higher budget next year. If the account is funded July 2025, for instance, and the gains would be taken in January of 2026, then the client would hypothetically have almost two years – until April 2027 – to pay the associated tax bill.
Many clients may appreciate having multiple years to prepare to pay the tax bill while their portfolio and investment strategy are aligned. In particular, high-net-worth investors really appreciate having clarity around their tax bill prior to the following April.
Automate tax budgeting with Envestnet Tax Overlay
The complexity of managing tax budgets across multiple accounts grows exponentially as you scale, making manual approaches impractical pretty quickly. That’s where Envestnet Tax Overlay comes in.
This advanced tax overlay solution:
- Continuously monitors portfolios to stay within the capital gains guidelines
- Respects each client’s unique tax constraints
- Alerts financial advisors when circumstances require the account to exceed its tax budget (i.e. large cash withdrawal)
- Allows clients to customize settings to balance the tradeoff between adhering to a capital gains budget and the potential risk of the account drifting from its target model
Instead of spending hundreds of hours manually analyzing tax implications for each account, advisors can use automated tax management services to reinvest their time in client relationships and business development.
Tax budgeting pays off
Having a conversation about tax budgets and building an effective budget can transform both client relationships and portfolio management. Clients appreciate the proactive approach and more predictable outcomes, while advisors can benefit from clearer decision-making frameworks and reduced year-end scrambling.
Tax budgets can also make tax planning an ongoing conversation rather than an annual afterthought. When tax considerations are integrated into regular portfolio discussions, and you can show clients exactly how you’re managing their tax exposure and coordinating it with their broader financial plan, you're positioning yourself as a comprehensive wealth manager, not just an investment provider.
Who knew that talking about taxes could be so rewarding.
Learn more about Envestnet Tax Overlay and how it can help you deliver smarter, more personalized tax outcomes for your clients.
