The tax efficiency of your portfolio is a sometimes overlooked consideration in financial planning and in assessing your investment’s total return. But not paying any more than you need to in taxes can have an outsize effect on your eventual net worth. That’s especially the case now for reasons described below. What follows are several ways – both strategic and tactical – to boost your portfolio’s so-called tax alpha. If you’re looking for ways to improve your investment results without putting more money into the market, which is what tax alpha does, consider working with a financial advisor.
What Is Tax Alpha?
Tax alpha, sometimes called alpha tax, measures how much an investor can add to his or her financial plan by optimizing efficient tax strategies and tactics. Essentially, tax alpha boils down to the ability of an investor to outperform reasonable returns by implementing tax strategies that lead to savings. In other words, it’s not about what you earn; it’s about what you keep.
Tax alpha is sometimes contrasted with tax drag, which refers to the reduction in after-tax returns that occurs as a result of realizing gains but then having those gains reduced because of taxes.
Why It’s More Important Now
There are several reasons tax alpha is emerging as more important than usual. One has to do with recent equity market performance. For the last 10 years stocks have turned in above-average returns. That has led some analysts to anticipate more modest gains and greater volatility.
In addition, tax hikes are looming. Because of changes adopted years ago, the current highest marginal income tax rate of 37% is set to rise to 39.6% after 2025. Also, while in 2022 the lifetime gift tax exemption is $12.06 million, it is scheduled to drop to about $6 million per person by 2026.
The combination of more modest returns, greater volatility and higher taxes makes achieving tax alpha more important than it might have been a few years ago.
How to Boost Your Tax Alpha
Boosting your tax alpha entails both strategic and tactical moves. Here are three moves:
Strategy: Put Assets in Their Tax-Compatible Accounts
Investors should hold tax-inefficient assets, especially those with higher growth potential, inside tax-advantaged accounts such as a 401(k), deferred compensation, IRA, Roth IRA or annuity. Candidates for tax-advantaged accounts are securities that are subject to income tax or short-term capital gains. Consider, too, putting these kinds of securities in a grantor trust where future growth is shielded from transfer tax.
Conversely, investors should seek to hold tax-advantaged securities, such as municipal bonds, in taxable accounts. Other candidates for taxable accounts are private equity assets since they typically are subject to long-term capital gains rather than short-term capital gains.
Tactic: Trading Moves to Limit Taxes
Increased volatility calls for more frequent tax-loss harvesting. Rather than wait till the end of the year to assess losses, it can pay to have your investments periodically reviewed for embedded losses. Also, consider in kind transfers if you want to move your securities from one brokerage to another. That avoids having to sell your securities and thus paying taxes on their gains before you can buy other securities for another brokerage account.
Finally, a separately managed account, a professionally managed account, gives account holders the ability to exercise selective realization of capital gains and losses to minimize taxes. One way to use this kind of an account is to have a realized gain limit, also known as a tax mandate, which will keep gains from exceeding the mandated limit and, thus, triggering confiscatory taxes.
Tactic: Non-Trading Moves to Limit Taxes
Aside from trading with tax awareness, tax alpha is enhanced with other tax-smart moves. Here are three of them:
- Gift giving: Consider donor-advised funds to avoid paying capital gains on appreciated assets. Likewise, consider qualified charitable distributions instead of a required minimum distribution from a traditional IRA to avoid paying taxes on the amount.
- Grantor retained annuity trust: While actually an irrevocable trust, it is essentially an annuity in which you bet that the value of the trust at the end of the annuity period will exceed a predetermined amount. It is effective at letting grantors avoid estate and gift taxes when passing large sums from one generation to the next.
- Lines of credit: Rather than sell securities – and thus incurring taxes – to fund an unplanned purchase, just use a line of credit, giving you time to raise the needed money in a tax efficient manner.
Who Is Really Capable of Achieving Tax Alpha?
The obvious gainers in the pursuit of tax alpha are the wealthy – not the middle class or working class – who have the resources to take the strategic and tactical steps needed, according to a study by the National Institute on Retirement Security. That’s especially so when it comes to defined contribution plans, the institute says. It recently published a study that found that more than half of the tax breaks for defined contribution plans and IRAs go to those in the top 10% by income. Also, the top 30% of workers by income receive 89% of the present value of tax benefits for defined contribution plans and IRAs. This leaves a “missing middle” because the tax code offers meager benefits for these working Americans to save for retirement.
“The value of tax incentives for saving is much greater for those at higher income levels, who face higher marginal tax rates,” according to the institute. “These incentives are quite weak for much of the middle class. Additionally, those who are able to invest earlier and at higher levels enjoy a greater advantage from the deferral of taxation on investment gains.”
Bottom Line
Sometimes it is more important to focus on what you keep instead of just focusing on what you earn, which is what tax alpha is all about. This is particularly important now given the prospect that equity returns will be more modest than those of the last 10 years, volatility looks poised to rise and higher taxes are on the horizon. Remember, that tax alpha should be pursued in both strategic and tactical ways.
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Tips on Taxes
- Tax planning to maximize what you get to keep can be complicated. That’s why the expertise and guidance of a financial advisor is so valuable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Marginal tax rates range from 10% to 37%. Use SmartAsset’s free tax calculator to get a quick estimate of what your federal income taxes will be.
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