# How to Calculate Tax Alpha

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Tax alpha, sometimes called alpha tax, measures how much an investor can add to their financial plan by optimizing efficient tax strategies. Essentially, tax alpha boils down to the ability of an investor to outperform reasonable returns by implementing tax strategies that lead to savings. Let’s break down how to calculate tax alpha. A financial advisor can help optimize your portfolio to mitigate your tax liability.

## How to Calculate Tax Alpha

Tax alpha is calculated by subtracting the excess pre-tax return from the after-tax return. The total excess after-tax return indicates how well your portfolio did as compared to a benchmark portfolio. In other words, excess after-tax return illuminates how much you gained from active tax management. While excess pre-tax return considers how well your portfolio did as compared to a benchmark portfolio.

Here’s the tax alpha formula:

Tax Alpha = Excess after-tax return – Excess pre-tax return

For example, let’s say that your portfolio’s pre-tax return is 9.30% and the benchmark pre-tax return for that portfolio is 9.20%. With that, your excess pre-tax alpha is 0.10%.

Next, you’ll need to calculate the total excess return by subtracting your benchmark after-tax return of 9.20% from your portfolio’s actual after-tax return of 10.10%. That leads to a total excess return of 0.90%.

Now, let’s plug the numbers into the formula to determine your Tax Alpha. In this case, that would be 0.90% – 0.10%, which equals a Tax Alpha of 0.80%.

The formula seems straightforward. But you’ll need to calculate both the excess after-tax return and the excess pre-tax return.

Determine the total excess return by adding up the benefit from loss harvesting, the benefit from gain deferral, and the benefit from active management.

Next, you can calculate the pre-tax return by determining the benefit from active management. Essentially, this is a benchmark to determine your portfolio’s expected growth pre-tax.

Once you have both of these numbers in hand, it’s easy to find the difference and determine your tax alpha.

In some cases, you’ll find a negative number. If negative, that means that strategy guidelines are changing, and your portfolio hasn’t been appropriately adjusted yet. Take this as a hint to work on your portfolio’s tax efficiency.

## Tax Alpha Strategies

Tax alpha can have a long-term impact on your portfolio. Here are some strategies to implement for a more tax-efficient portfolio.

Tax loss harvesting. Tax-loss harvesting is one investment strategy that strives to harness the losses from one asset to offset the gains of another asset.

For example, let’s say that you have a holding that has skyrocketed in the past year. But another one of your stock holdings has lost a significant portion of its value. If you wanted to implement tax-loss harvesting, then you would sell the low-performing asset to offset the gains of the high-performing asset.

Beyond offsetting high-performing investments, you can use losses to offset up to \$3,000 in ordinary income. Additionally, you can use any additional losses on future tax returns.

Direct indexing. Direct indexing is one type of index investing that harnesses passive investing and tax-loss harvesting. As a direct indexing investor, you would use an index as a guide to buying up every single individual security within a particular index.

With direct indexing, you can make individual moves within your portfolio to take advantage of the tax-loss harvesting strategy we explored above.

Tax-advantaged accounts. Tax-advantaged accounts allow you to build an investment portfolio that’s either tax-free or tax-deferred. As an investor, it’s smart to make use of tax-advantaged accounts.

If you have more tax-advantaged investment accounts, then your tax savings will add up quickly. A few examples of tax-advantaged accounts include Individual Retirement Accounts (IRAs), Health Savings Accounts (HSAs), and 401(k)s.

Each of the tax-advantaged accounts has an annual contribution limit. But as savvy investors still make sure to use these tax-advantaged accounts as much as possible. Before committing to a tax-advantaged account, take the time to read the withdrawal rules. Many of these accounts have limitations on how and when you can use the funds.

## How to Implement Tax-Efficient Strategies

Tax alpha is a goal worth pursuing for many investors. After all, no one wants to overpay when it comes to their tax bill. If you want to implement tax-efficient strategies on your own, then the first thing to do is start learning. SmartAsset offers an extensive collection of resources about taxes. Take the time to learn the ins and outs before applying any particular tax strategy to your portfolio.

In some cases, a tax-efficient strategy is not something that you have time to implement on your own. If you are tight on time, then reach out to a financial advisor. The right financial advisor can help you find the right tax strategy for your financial goals and risk tolerance.

## Bottom Line

A tax efficiency strategy can pay off big in the long term. But building a portfolio with impressive tax alpha is not always easy. So, if you need help mapping out and implementing tax strategies that work for your financial future, consider speaking with a financial advisor. They can guide you through the process.