Generating tax alpha is done by holding assets in types of accounts that are more favorable than others. As a general principle, investors should locate assets that would be taxed heavily in tax-advantaged accounts and hold more lightly taxed assets in taxable accounts. More lightly taxed can refer to either lower tax rates and/or tax deferral.
On this page, we discuss some of the basic principles behind generating tax alpha
Tax alpha definition
Tax alpha is the value created by effective tax management of investments. Since there is a limit on how much can typically be placed in tax-deferred locations, very often it means that it is better to hold bonds in tax deferred counts. This is because bonds produce most of their return from coupons.
Equities, on the other hand, can be held in taxable accounts since the equity return is typically made up mostly of capital gains rather than dividend income and capital gains can be deferred.
Another approach to limit the impact of taxes is to extend the holding period as much as possible. Often, long-term capital gains are taxed at a lower rate than short-term capital gains. Thus, keeping the assets for a longer time in a fully taxable account is a second method to reduce the tax drag.
Tax alpha has little to do with picking mispriced securities and timing the market. Instead, these strategies make use of the available tax saving strategies to reduce the impact of taxed on the after-tax return. Because of compounding, taxes can have a very big impact of the terminal value of an overall portfolio.
Moreover, since there’s no risk involved and tax alpha can be obtained by spending just a little bit of time in optimizing the asset allocation, it should be pursued by all investors.
We discussed how to create alpha by improving the after-tax return, an approach investors can use to minimize the impact of taxes on net-returns.