Tax alpha is an aspect of investment portfolio management whereby strategies are utilized to reduce, delay or eliminate taxation. The tactics that are utilized are not “schemes” and are not implemented in an attempt to not pay tax. Tax minimization is not the primary consideration in investment management, but it should be a factor when allocating and making adjustments to a portfolio.
Tax alpha can benefit all portfolios regardless of whether they are owned by trusts, corporations or individuals. The benefits are certainly relative to the size of the taxable assets and can benefit even small portfolios. The greatest impact, however, is likely to benefit those who are faced with the highest marginal ordinary income tax rate and large portfolios. The reason for this is the variance between the long-term capital gains rate and the marginal ordinary income rate when making holding period decisions.
Taxation is one of many costs working against maximizing portfolio returns. Commissions, fees, interest and many other factors seem to be proactively managed while taxation tends to be overlooked. Portfolios are managed throughout the year, tax statements are delivered to the portfolio owner, who forwards them without looking at them, to the CPA who enters the data into software that produces the tax return. In this too-frequent scenario, nobody takes responsibility for minimizing the portfolio’s tax consequences. The effect of taxation on portfolio returns should be the responsibility of the portfolio manager and stated as such in an Investment Policy Statement.
Tax alpha is produced using a number of different strategies: tax loss harvesting, gain resets, asset location, holding period management and security type selection.
Tax loss harvesting is generally executed at the end of the year but can be utilized at any time. If the portfolio has realized gains (securities were sold at some point during the year), securities that will produce a loss are sold in order to offset those gains. This is a simple explanation, but when harvesting losses, investors need to be aware of the difference between short-term and long-term gains rates and how losses are applied to gains. One also needs to be mindful of the IRS’s wash sale rule, which requires the investor to wait no fewer than 31 days to repurchase the same security in order to deduct losses.