Investors are always on the lookout for “alpha.” That is, the extra returns added by management skill above and beyond the returns of the market itself.
Since the onset of the Great Recession, the search for alpha has become urgent, as fixed-income investors lament a low-interest rate environment and equity investors lament sluggish economic growth.
One of the ways the wealthy are dealing with this problem is by getting serious about Tax Alpha. Or in other words, by paying attention to the additional after-tax return they can capture by implementing tax minimization strategies. The idea being that it’s often easier to boost returns by minimizing taxes than it is by picking the right stocks.
Think about it: taxes are by and large within the realm of your control. If you want to pay less tax, you can often take actions or make decisions that will lower your tax bill. You can’t always do that with your portfolio – you’re at the mercy of much larger forces.
In my experience, it’s usually possible to add 2% to 3% in portfolio performance by paying attention to Tax Alpha.
That’s a considerable boost, particularly in times when market performance is unpredictable or downright difficult.
The goal of a Tax Alpha strategy is not to save you a couple of bucks in April. Rather, it’s a concentrated and co-ordinated effort to minimize tax. I say “concentrated” because minimizing tax becomes a primary focus of your financial decision-making and “co-ordinated” because the effort takes place across multiple aspects of your financial affairs.
Tax Alpha takes place on two levels:
(a) structural: organizing financial affairs to minimize the amount of income lost to tax; and
(b) portfolio: making investment decisions that minimize the amount of investment returns lost to tax.
Giving you a full list of actionable ideas on each of these levels would take much more room than I have here?.
But let me give you an overview of some of the more common strategies I see the wealthy using, along with a brief rationale for why they’re using them.
Structural strategies
•Holding companies? – a very popular strategy with business owners and ex-owners, because it allows for the payment of tax-advantaged dividends to owners and their children.
•Family trusts ?– an effective way to add Tax Alpha, regardless of net worth. Because trust income is taxed at its own marginal rate, trusts allow you to move income from family members in a high tax bracket to those in a low tax bracket.
•Spousal trusts? – offer significant tax savings for surviving spouses living off the income of assets within the trust. For those with large estates, this can defer thousands of dollars of tax.??
Investment strategies ??
•Corporate class funds ?– these allow investors to minimize taxes on distributions and dispositions when you switch between funds within the fund family. Investors with larger accounts can often negotiate lower fees, bringing management expense ratios closer to those of ETFs.
•Dividends? – ?by emphasizing dividends (which receive preferential tax treatment) over interest-producing investments (which don’t), you can save yourself a great deal of tax. The wealthy have shifted portfolio allocations over the past several years to take advantage of these rules.
•Return of capital structured investments ?– a way to receive regular income without being taxed as regular income. Closed-end funds are an example – although admittedly, not all CEFs use such payments in a shareholder friendly way. Make sure to do your homework if you’re interested. •
