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'Tax alpha' is much more than simple tax-efficiency

  • The basics of tax alpha, at a minimum, call for tax-efficient investing.
  • Other considerations include tax-loss harvesting and attention to asset allocation.
  • The order of retirement account drawdowns determines how much tax is paid immediately and in the future.

You may have heard about the concept of "alpha" — that extra bit of performance a manager can generate, through skill, on top of ordinary market returns. Tax alpha, on the other hand, is the outperformance that an investor can achieve by taking advantage of all the available tax-saving strategies. Obviously, the bigger the tax liability, the more tax savings can be realized.

"Tax alpha needs to start the day you enter the workforce," said CPA Robert Keebler, a partner at Keebler & Associates.

You shouldn't confuse tax alpha with tax efficiency, financial advisors such as Keebler noted. It goes much deeper than that. And although it's hard to measure exactly how much of a performance edge tax alpha lends to overall portfolio returns over a lifetime of saving and investing — Keebler, for his part, believes it could be as high as 2 percent — it can be significant.

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"It's about looking at all your financial moves through the lens of maximizing after-tax returns," said Tim Steffen, director of advanced planning at R.W. Baird & Co.'s private wealth management group.

Some of those decisions are:

  • Buying a house or investing.
  • Contributing to a Roth or taking an upfront tax deduction with a traditional individual retirement account (IRA).
  • Moving to a low-tax state or living in a more heavily taxed one that has the potential for better career advancement.

In a paper from 2014, research firm Morningstar found that a laser focus on better financial decisions could add 1.82 percent a year of extra earnings, a concept the investment research firm dubbed "gamma." Among the strategies Morningstar singled out were things such as optimal asset allocation, incorporating annuities and smart tax moves.

Start with tax efficiency

The basics of tax alpha call for tax-efficient investing at a minimum. While some funds may have a strong history of returns, they may have come at the expense of taxes, Steffen noted. You'll have to dig a bit to understand what your net gain will be.

Exchange-traded funds "have become so popular, in part, because indexing is so tax-efficient, and the ETF structure makes the investment even more tax-efficient," he said.

First, index funds keep turnover low because they only buy and sell securities when there's a change in an index's composition. By not engaging in rapid trading, there are no capital gains to realize. ETFs go one step further. They are not required to distribute what capital gains there are to shareholders, unlike mutual funds, which must.

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"There's no question about it, ETFs have better tax efficiency than mutual funds," said CPA and financial planner Theodore Sarenski, CEO and president of Blue Ocean Strategic Capital.

For investors who need even more tax alpha, separately managed accounts are able to fine-tune each investor's tax liability while still being professionally managed. Instead of owning shares of a fund, SMA investors own their securities directly, even if they are replicating an index. That provides more flexibility. They can use any losses in the account to offset losses anywhere else in their portfolio, not just that particular strategy.

However, it's not a given that SMAs are tax-efficient.

"The direct ownership can help you reduce taxes, but if the manager you use is a momentum investor where they're trading all the time, there's going to be tremendous turnover," said Sarenski. "How tax-efficient is a manager like that going to be?"

Taking investing a step further

Tax alpha doesn't end there. There are more strategies to make sure a huge tax bill isn't lurking in your portfolio.

The first is tax-loss harvesting, where investors sell securities at a loss in order to cancel out a gain elsewhere. If there aren't enough gains to offset the losses, you can carry them over into future years. Plus, you can use up to $3,000 of losses against that year's current income.

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The other strategy is to think carefully about where you hold your investments, which is known as asset location. Different types of gains have different tax treatments. For example, capital gains and dividends are taxed at the favorable rate of 15 percent or 20 percent (and possibly 0 percent, depending on your income). Coupon payments from bonds and dividends from real estate investment trusts, on the other hand, are taxed as ordinary income.

Where you hold them can make a big difference.

"I prefer to put the fixed income into a retirement account, which is tax deferred," said Steffen at Baird. "I like to have capital appreciation in an account where you get a favorable tax rate."

Withdrawals are key

Taxes come to the fore in a big way when it comes time to take distributions from a retirement nest egg. How you draw down your retirement savings will impact how much you're able to spend in retirement.

"You arrive at retirement, and you have this mosaic of assets and you have to figure out how do I make my money last," said Keebler at Keebler & Associates.

The order of drawdowns determines how much tax you pay immediately and in the future.

"I like to have capital appreciation in an account where you get a favorable tax rate." -Tim Steffen, director, advanced planning, Baird's wealth management group

As a general rule, it's best to start with taxable accounts while your tax-deferred or tax-free accounts continue to grow. Long-term investment assets are mainly subject to the capital gains rate. Money from traditional 401(k) plans and IRAs are charged the ordinary income tax rate, which could run as high as 39.6 percent on top of a 3.8 percent Medicare surtax for high earners.

Advisors recommend saving Roths for last, so they can continue to compound tax-free. Earnings and withdrawals from Roths are tax-free and there's no required minimum distribution starting at age 70½, unlike the traditional versions of the accounts.

Because taxes are highly individualized, there are a myriad of tax alpha strategies. You don't have employ each one, but continually spotting opportunities for tax savings can easily boost portfolio returns.

— By Ilana Polyak, special to CNBC.com

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