When most investors hear the word “alpha,” they think performance. It’s the classic measure of how much value a portfolio manager or investment strategy adds beyond what the market already provides. That kind of alpha matters, of course, but it isn’t the only source of added value in a well-designed portfolio.
There’s another form of alpha that often flies under the radar: tax alpha. This is the value created by managing your investments with taxes in mind. While no one can avoid taxes altogether, thoughtful planning can help narrow the gap between your before-tax and after-tax returns. Generally speaking, the closer the gap, the more tax-efficient your portfolio is.
With that in mind, let’s explore why tax alpha deserves more attention and some practical ways to pursue it in your own portfolio.
The Basics of Tax Alpha
As your portfolio grows, market movements become just one component of your overall investment performance. Two investors can make the same investment decisions and earn the same market returns, yet end up with very different after-tax results depending on how their portfolios were structured and managed.
The U.S. tax code is notoriously complex. Buried within that complexity, however, are strategies for meaningfully reducing your tax burden, both today and over the course of your lifetime. If you’re a business owner, you have access to even more strategies for reducing your taxable income than W-2 or wage employees.
A knowledgeable advisor can help you identify and leverage the appropriate tax-minimizing strategies at the right times, based on your income, portfolio structure, and long-term goals.
How Do I Achieve Tax Alpha?
Achieving tax alpha usually requires investors to use a combination of tax-focused decisions that work together within their portfolio over time. Here are a few of those strategies:
Follow a Retirement Contribution Strategy
Retirement plans remain one of the most effective tax-advantaged vehicles available. As an investor, it’s important to evaluate which type of account to contribute to and when, based on the contributions’ current and future tax treatment.
Depending on your taxable income today and anticipated income levels in retirement, it may make sense to prioritize:
- Pre-tax contributions if you’re trying to reduce your taxable income today
- Roth contributions if you’d like potentially tax-free withdrawals in retirement
- After-tax contributions if you’re considering pursuing a mega backdoor Roth strategy
Business owners and solopreneurs have some additional options for tax-advantaged retirement savings, beyond the typical 401(k) or IRA. Through tools like SIMPLE IRAs, solo 401(k)s, SEP IRAs, and more, you may be able to leverage all three tax types to really optimize your portfolio’s take-home returns in retirement.
In the event you already have a large pre-tax account, like a 401(k) or IRA, you can still find opportunities to optimize your tax liability before retirement. Some advisors, for example, incorporate tax-aware hedge funds or other alternative strategies to help offset ordinary income, particularly in years when an investor may be completing significant Roth conversions or realizing higher-than-usual taxable income.
Consider Asset Location
Asset location refers to which accounts your investments are housed in (taxable, pre-tax, tax-free, etc.).
Asset location is important to consider, particularly when pursuing tax alpha, because different investments generate different types of taxable income. Placing them in the right accounts can help reduce unnecessary tax liability.
For example, tax-inefficient investments like taxable bonds or private credit often fit best inside retirement accounts (401(k)s, IRAs, and Roth accounts) since the interest and income earned aren’t taxed annually.
On the other hand, tax-efficient investments (long-term growth stocks or certain types of real estate) are generally better suited to taxable or brokerage accounts, where lower long-term capital gains rates may apply.
Finding opportunities to optimize asset location across accounts is a simple but powerful way of enhancing after-tax performance without changing your risk level.
Harvest Losses
Seeing the effects of market volatility hit your portfolio is never fun, but it can create an opportunity to generate tax alpha. When markets dip, you may sell investments that have temporarily declined in value and “harvest” the loss. These losses can then be used to offset current or future capital gains, or even reduce up to $3,000 of ordinary income each year.
Direct indexing solutions are used to replicate an index (like the S&P 500) while holding the underlying securities directly. For some investors, they can provide the customization and flexibility necessary to harvest losses effectively. You can take this to the next level by using a long-short direct indexing strategy to track and index and potentially harvest even more losses. These strategies are great for those who may be looking to sell appreciated company stock, shares in a partnership, or other business interests down the line. You can carry harvested losses in perpetuity, so there is a great opportunity to reduce or eliminate gains down the line.
Gift Strategically
While you may gift up to the IRS’s annual limit without incurring taxes, doing so does create a disadvantage for your loved ones. Gifts to heirs do not receive a step-up in cost basis, which is the rule that allows the cost basis of an investment or asset to “reset” to the day the previous owner passed. The benefit of a step-up in cost basis is that the inheritor can sell it right away and incur very little (or no) capital gains. Even if they choose to hold onto the asset and let it grow, the cost basis will (presumably) be higher when the time comes to sell, which will lower their taxable gains.
Without a step-up in cost basis, your heirs may owe capital gains tax on the appreciation you transfer to them today.
A more tax-efficient strategy may be to gift appreciated assets to charity, where gains are not subject to tax, or place the funds into a charitable trust. If you’d prefer to keep the assets within the family, it may be most beneficial to delay gifting any highly appreciated assets until death, when the cost basis resets.
If you’re already taking (or approaching) required minimum distributions, Qualified Charitable Distributions (QCDs) are another powerful tool to consider. By donating RMD dollars directly to charity, those distributions are excluded from taxable income entirely. This can help control your adjusted gross income, which in turn affects Medicare premiums, NIIT exposure, and other tax thresholds.
Pursuing Tax Alpha
As an investor, it’s important to consider how your decisions impact your tax bill today and through retirement. You and your advisor can find opportunities to structure your portfolio so that more of your returns work for you. While tax laws are always changing, opportunities to strategize and optimize your tax situation remain constant.
If you have questions about your portfolio’s tax effectiveness, or you’d like to discuss some of these tax alpha strategies together, we encourage you to reach out to our team today.
Sean Gerlin, CFP®, CPWA®, ChFC®, CLU®, is the Founder and Principal of Envision Wealth Planners, a fee-only financial advisory firm based in the greater Orlando area. Sean specializes in helping high-income families, business owners, and commercial real estate executives align their wealth with their values through a comprehensive Financial Life Planning approach. Learn more about them at envisionplanners.com.
This material has been edited with the assistance of artificial intelligence tools. The information presented is based on sources believed to be reliable and accurate at the time of publication. This material is for educational purposes only and does not necessarily reflect the views of the author, presenter, or affiliated organizations. It should not be construed as investment, tax, legal, or other professional advice. Always consult a qualified professional regarding your specific situation before making any decisions.