Tax Alpha: Elevating Returns beyond the Portfolio

If you’ve been around investing and financial information for a while, you may have heard the term “alpha.” Alpha is the measurement of the performance advantage gained by some means, such as the specific investment strategy of a particular fund or manager. “Positive alpha” means that the investment outperformed its benchmark, such as a specific index, while “negative alpha” indicates underperformance. So, “alpha” is simply the measure of an investment’s “edge” or excess return when measured against a norm or benchmark.

For high-earning and high-net-worth investors, “tax alpha” may be a valuable indicator of a portfolio’s wealth-building efficiency. In other words, an efficient tax strategy may be almost as important as portfolio performance for efficiently building and preserving long-term wealth. But how can tax alpha be achieved? Let’s take a look at some often-overlooked strategies that can boost after-tax returns and increase tax alpha for the portfolio.

Strategic Asset Location

Sometimes, where you own assets can be as important as what you own, especially where tax-efficiency is concerned. Assets generating above-average income, such as dividend-paying equities or high-interest bonds, could be best held in accounts like IRAs or 401(k)s, where their growth and income is shielded from tax liability. On the other hand, it may be advantageous to hold assets intended for long-term appreciation, such as growth stocks, in a taxable account. As long as the assets are not sold, their gain is not taxed, and as long as they are held for a year or more before the sale, the increase in value (capital gain) will be taxed at a rate that is typically much lower than the seller’s ordinary marginal rate.  

Bottom line: tax alpha can be achieved by placing your most tax-efficient investments in taxable accounts, and your least tax-efficient investments in tax-advantaged accounts. And by the way: don’t underestimate the importance of maximizing contributions to tax-advantaged accounts.

Manage Turnover

Excessive buying and selling activity in the portfolio not only reduces tax alpha (by generating short-term gains that are taxed at the same rate as ordinary income); it also diminishes long-term growth by incurring fees and other transaction costs. On the other hand, a focus on holding assets for a year or more tends to increase portfolio efficiency, both cost-wise and tax-wise.

Tax-Loss Harvesting

This tool typically gets a lot of press near the end of the year, when investors are looking for ways to reduce the size of the check they’ll need to write to the US Treasury the following April. But as part of an overall tax-efficient portfolio, tax-loss harvesting is a component of sound financial planning best practices.  

At its most basic, tax-loss harvesting simply means recognizing losses in one part of the portfolio that can be used to offset gains in another part. Often, tax-loss harvesting can be harnessed together with regular portfolio rebalancing, when necessary to keep the asset allocation in the established proportions for the financial plan.

Particularly in years when the financial markets are volatile or when other income has been higher than usual, tax-loss harvesting can both help “trim the sails” for future growth and reduce the tax burden for the investor.

Income Shifting and Gift Exclusion

For high-net-worth families, especially those building and preserving generational wealth, it may be advisable to utilize certain estate-planning tools to shift income to entities with a lower tax profile. In consultation with a qualified estate planning professional, vehicles such as spousal retirement accounts, family partnerships, or trusts may be used to divert income from a person in a higher tax bracket to a family member in a lower bracket, thus lowering the overall tax burden for the family.

Looking toward the tax-efficiency of the eventual transfer of the estate, affluent individuals may also wish to make use of the annual and lifetime gift exclusions, which allow for transfer of assets to heirs and others while reducing the size of the taxable estate. By systematically using annual gifts, persons can work to ensure that the value of the estate, when transferred to non-spousal beneficiaries, is subject to the smallest estate tax burden legally permitted.

Philanthropy

Many wealthy individuals and families place a great value in giving back to their communities by supporting worthy charitable causes. In fact, “doing well by doing good” is another important tool for managing the tax burden on significant wealth. It may be advisable to donate highly appreciated assets through the use of charitable trusts or donor-advised funds (DAFs). Many DAFs are capable of accepting most types of assets, including appreciated real estate, business interests, and others, generating a tax-deductible gift for the donor and allowing the donor to direct the distribution of the gift to preferred qualified charities over a period of years, if necessary.

Advanced Insurance Structures

For accredited investors, private-placement life insurance (PPLI) may enable the holding of investments like private equity, hedge funds, and other complex assets within an insurance contract. While this is a sophisticated product requiring careful planning, PPLI, especially when held in an irrevocable life insurance trust (ILIT) may allow for tax deferral on the proceeds and tax-free transfer to heirs upon the death of the insured.

At GEM Asset Management, we understand the importance of tax efficiency and its effect on building and maintaining wealth. If we can help you “ask better questions” about building and maintaining your wealth, please get in touch.