What Is Tax Alpha & Why Should I Care?

What Is Tax Alpha & Why Should I Care?

March 06, 2023

Everyone wants to optimize their taxes. Full stop. The problem is—aside from a few smart deductions, most people don’t actually know how to do that.

That’s where tax alpha comes in. Tax alpha is an investment strategy that seeks to do two things: maximize investment returns and minimize the amount of taxes owed. 

If it sounds complicated, that’s because it is—you need meticulous planning and experienced tax management to achieve tax alpha. But it’s also one hundred percent worth the effort.

By creating an investment plan with tax alpha in mind, you can reduce the amount of taxes you owe. That means greater returns (in both the short term and long term). If that sounds good, let’s do a deeper dive into tax alpha, how it works, and why it's important to understand. Then, we can dig into some more advanced strategies.

Portfolio Creation & Management Strategies

There’s no sugarcoating it: creating and managing a successful investment portfolio is a daunting task. You have to consider a lot of factors, including your risk tolerance, goals, and timeline, if you want to craft a portfolio that actually meets your needs. 

But this isn’t a one-size-fits-all deal, nor is it something you can retrofit into a pre-existing strategy. It's better to create a tax-optimized investment portfolio from scratch rather than adjust as you go.

Ask yourself: “which types of accounts will best suit your investment objectives?” 

Taxable, Tax-Deferred, & Tax-Exempt Accounts

Let’s take a look at three types of accounts:

  • Taxable accounts are funded with post-tax income. Any capital gains generated within the account are taxed at the investor's marginal tax rate. 
  • Tax-deferred accounts, such as 401(k)s and Traditional IRAs, allow investors to delay paying taxes until they withdraw the funds in retirement. Capital gains will be charged when you decide to withdraw your funds.
  • Tax-exempt accounts, such as Roth IRAs and Roth 401(k)s, don't impose taxes on withdrawals (because they come from taxable income). 

Your best bet is likely to invest in a mix of taxable, tax-deferred, and tax-exempt accounts. You may want to consider whether you plan to hold investments for the long term or pursue short-term investments, as this affects how heavy your tax load will be.

Long-term investments, defined as those held for more than one year, are often taxed at a lower rate than short-term investments (held for under one year). Long-term capital gains are typically taxed at 15%, while short-term capital gains are taxed at the same rate as ordinary income. 

For example, if you are in the 22% tax bracket, then your short-term capital gains will be taxed at 22%. 

How Long-Term & Short-Term Investment Strategies

How much do you get taxed on your investments? Depends how long you hold them. 

Short-term investments are those held for one year or less, while long-term investments are held for longer than one year. 

Short-term investments are taxed as ordinary income, meaning that the investor pays their normal income tax rate. That can range from 10% to 37%, depending on your bracket. This tax rate applies to any investments held in a taxable account, regardless of whether the investment was short-term or long-term. 

Long-term investments, on the other hand, are subject to lower capital gains tax rates:

  • For taxpayers in the 10%, 12%, 22%, 24%, 32%, and 35% marginal tax brackets, long-term capital gains can be taxed at 0% or 15. 
  • For taxpayers in the 37% marginal tax bracket, long-term capital gains are taxed at a 20% rate. 

For example, let’s say you have a taxable account with $50,000 in investments and have made a gain of $5,000 over a year. If your marginal tax rate is 24%, then you would pay $1,200 in taxes on the $5,000 gain ($5,000 x 24%). 

However, if you hold your investments for longer than one year and your marginal tax rate is still 24%, then you would only owe $1,000 in taxes on the $5,000 gain ($5,000 x 20%). 

When investing in a tax-advantaged account like an IRA or 401(k), there is no difference between short-term and long-term gains. Any gains aren’t taxed until you decide to take your money out. This makes it the move to minimize your current tax burden. 

Ultimately, the more you know, the more you can achieve.

Short-Term Investing

Short-term investors typically try to capitalize on market movements in order to maximize their returns. This means rapid buying and selling of assets with the hope of making a quick profit. 

Yes, these types of investments can be extremely lucrative. But, they’re also high-risk. You need to keep an eye on taxes when investing like this. 

Consider strategies like tax-loss harvesting, which lets you offset capital gains with losses from other investments.

Long-Term Investing

Got a big picture mindset? Long-term investors focus more on the long-term performance of the asset rather than rapid market movements. That means stocks, bonds, mutual funds, or ETFs (with the goal of holding them for multiple years). 

This type of investment typically results in lower returns and less market volatility. With this, you can take advantage of lower capital gains tax rates since they have held the asset for more than one year. Want to reduce overall tax liability and increase after-tax returns? This is the move for you. 

Tax-Optimization Strategies

Here’s where it gets interesting.

Investors can maximize their after-tax gains by taking advantage of the different tax treatments that different investments receive. 

Some common tax-optimization strategies include:

  • Tax-Loss Harvesting: Tax-loss harvesting is a strategy investors use to offset capital gains from other investments. By strategically selling losing investments at the end of a tax year, an investor can use those losses to offset any capital gains from other investments. Note: this needs to be done in a taxable account to realize the benefit.
  • Diversifying Asset Location: Different investment types are treated differently by the IRS, so diversifying the location of your investments can be an effective way to minimize taxes. Placing certain investments in tax-advantaged accounts like IRAs or 401(k)s can be an effective way to reduce your overall tax burden.
  • Investing in Municipal Bonds: Municipal bonds are issued by local governments to finance public projects. They can be tax-exempt from federal and state taxes, making them an attractive option for those looking to minimize their tax burden. 
  • Utilizing Exchange Traded Funds (ETFs): Exchange Traded Funds (ETFs) can provide investors with broad diversification in one fund. ETFs are often tax-efficient due to their unique structure, which minimizes taxable events like capital gains. 

Consulting with a qualified financial advisor can help you select the right tax optimization strategies for your portfolio. 

How Tax-Smart Investors Allocate Their Investments

Tax-smart investors see the big picture—properly allocating your investments is a complete game-changer. Tax-advantaged investment accounts, such as a 401(k) or IRA, are often ideal for long-term investments, while taxable accounts are better suited to short-term investments.

Tax-advantaged investment accounts offer a range of tax benefits that allow you to defer or avoid taxes on certain investments. 

Popular tax-advantaged accounts include: 

  • Traditional IRAs and 401(k)s;
  • Roth IRAs;
  • 529 college savings plans; 
  • Health savings accounts (HSAs);
  • Coverdell Education Savings Accounts; and 
  • Individual retirement accounts (IRAs). 

Generally, these accounts are best suited for long-term investments.

Taxable accounts are best used for short-term investments, such as trading in stocks and other securities. 

These accounts do not offer any tax benefits, and any profits made will be subject to capital gains taxes. Short positions on individual stocks may also be placed in a taxable account.

When deciding how to allocate investments, it’s important to consider the types of investments being made and their potential taxes. For example, long positions on individual stocks may go into either tax-advantaged or taxable accounts, depending on your goals. 

Combining Portfolio Management With Tax Optimization Strategies to Achieve Tax Alpha

Tax alpha is about having both a big picture mindset and attention to the details. 

Creating an effective portfolio management strategy that considers short-term and long-term investment strategies and proper tax management will help you reduce taxes and increase returns. 

If you’re a tax-smart investor, you allocate your portfolio based on the tax implications of each investment type. And, in the long run, you’re likely to benefit.  

Key Takeaways

By taking into consideration both portfolio management strategies and tax optimization strategies when creating your portfolio, you can ensure you’re taking full advantage of potential tax savings while managing your investments effectively: 

  1. Figure out which types of investments best suit your goals, risk tolerance, and timeline.
  2. Allocate investments to taxable, tax-deferred, or tax-exempt accounts based on their tax implications.
  3. Take advantage of opportunities to reduce taxes on capital gains, such as by setting up a sell-off schedule for assets held for more than one year.
  4. Work with a qualified financial professional or tax expert if you need assistance with building an effective portfolio management strategy with tax optimization in mind.