Tax Alpha 101: How High-Net-Worth Investors Can Boost Returns by Managing Taxes Effectively | Allworth Financial

As a high-net-worth investor, you’ve likely spent years or even decades building your wealth through savvy investment strategies. But taxes are one of the biggest drains on wealth. That’s where tax alpha comes in—a concept that can optimize your investments so you keep more of what you earn, giving you a critical edge over time.

What is Tax Alpha and Why It Matters

Tax alpha is a term used to describe the additional value that an investor can achieve by managing taxes effectively within their investment strategy. While most investors focus on generating high returns, tax alpha is all about ensuring that those returns are not significantly diminished by taxes.

While it’s impossible to avoid taxes entirely, it is very possible to manage them in ways that enhance the efficiency of your portfolio.

The Tax Impact of Different Asset Classes

Each asset class—whether it’s stocks, bonds, or real estate—comes with its own set of tax implications. Understanding these nuances is essential for constructing a tax-efficient portfolio. For instance:

• Stocks: In most cases, long-term capital gains (on investments held longer than one year) are taxed at lower rates than short-term gains or ordinary income. For high-net-worth investors, this means that holding stocks for the long term can significantly reduce the tax burden on your investment returns.
• Bonds: Interest income from bonds is typically taxed at ordinary income rates, which can be quite high for high-income earners. To reduce the tax impact, consider using municipal bonds, which are often tax-exempt at the federal level, or placing bonds in tax-advantaged accounts like IRAs.
• Real Estate: Real estate investments come with their own tax considerations, including depreciation (which can offset rental income) and capital gains when selling property. Holding real estate long term allows you to take advantage of 1031 exchanges, which defer capital gains taxes on the sale of investment properties.

When constructing your portfolio, it’s important to evaluate the tax efficiency of each asset class and align your holdings with your overall tax strategy.

A Tax-Efficiency Checklist for Investors

To help you take advantage of tax alpha, here’s a checklist of tax-smart decisions that high-net-worth investors should consider making:

1. Hold Investments for the Long Term: The longer you hold an investment, the more likely it is that you’ll qualify for long-term capital gains tax rates. Aim to buy and hold investments for over a year.
2. Utilize Tax-Deferred Accounts: Contributing to tax-deferred retirement accounts like IRAs and 401(k)s allows you to delay taxes on your investment gains until you withdraw them in retirement. This gives your investments more time to compound without the drag of taxes.
3. Consider Tax-Free Accounts: If you're in a high tax bracket, consider using Roth IRAs or Health Savings Accounts (HSAs). These accounts allow your investments to grow tax-free, meaning you won’t have to pay taxes on the gains when you withdraw them. This is also what makes a Roth conversion a powerful wealth planning tool.
4. Leverage Tax-Advantaged Investments: Explore investments that offer tax advantages, such as the aforementioned municipal bonds and real estate. Master Limited Partnerships (MLPs) and private equity funds may also offer unique tax advantages, such as the ability to generate income that is taxed at lower capital gains rates or provides opportunities for deferral.

Tax-Loss Harvesting and Asset Location Strategies

Two critical strategies for enhancing tax alpha are tax-loss harvesting and asset location. While tax-loss harvesting can provide immediate relief by offsetting gains with losses, asset location focuses on placing different types of assets in the right types of accounts to minimize taxes over the long term.

Tax-loss harvesting involves selling investments that have lost value to offset gains from other investments. The idea is to use losses to reduce your taxable income and thereby lower your tax bill. This strategy is particularly valuable during volatile market periods when some of your holdings may be down in value, or in years with higher-than-normal income. (At Allworth we make this easy, utilizing industry-leading software to automatically do this for client portfolios.)

Asset location refers to the process of strategically placing different types of investments in the most tax-efficient accounts. For example, you might place high-income-producing assets (such as bonds or dividend-paying stocks) in tax-deferred or tax-free accounts and growth-oriented assets (such as stocks) in taxable accounts to take advantage of lower long-term capital gains rates.

The key is to place your least tax-efficient investments in tax-advantaged accounts, and your most tax-efficient investments in taxable accounts.

Real-Life Examples of Tax Alpha in Action

To illustrate the power of tax alpha, let’s look at a very simplified example of two investors—Investor A and Investor B—with identical initial investments of $1 million, an 8% annual return, and a 20-year investment horizon. Both investors aim for the same gross return, but their approaches to taxes differ.

Investor A is proactive about tax efficiency. They focus on:

• Holding investments for the long term to qualify for long-term capital gains rates (20%).
• Using tax-deferred accounts (e.g., IRAs, 401(k)s) to delay taxes on interest and capital gains.
• Practicing tax-loss harvesting to offset gains with losses, reducing taxable income.

Outcome:

• Without taxes, Investor A’s portfolio grows to $4.66 million over 20 years (8% annual return).
• After long-term capital gains taxes (20% on $3.66 million of gains), they owe $732,000 in taxes, leaving them with $3.93 million after taxes.
• By harvesting $100,000 in loses, Investor A could save around $20,000, bringing the final after-tax total to approximately $3.95 million.¹

Meanwhile, Investor B doesn’t focus on taxes. They:

• Frequently sell assets within one year, triggering short-term capital gains taxes (37%).
• Don’t utilize tax-deferred accounts fully and overlook tax-loss harvesting.

Outcome:

• Without taxes, Investor B’s portfolio also grows to $4.66 million over 20 years.
• They pay 37% tax on half of the gains ($2.33 million), totaling $862,000 in taxes.
• They also pay 20% tax on the remaining long-term gains, costing them $466,000 in taxes.
• Total taxes owed: $1.33 million, leaving them with $3.33 million after taxes.

Overall, the difference is $620,000 more for Investor A—18.6% higher after-tax returns—simply by implementing tax-smart strategies like holding investments long-term and tax-loss harvesting.

Make Tax Alpha a Priority

When it comes to wealth management, it’s not just about how much you earn—it’s about how much you keep—making tax alpha one of the most powerful tools available for high-net-worth investors looking to optimize their portfolios and improve their after-tax returns.

Ready to make tax efficiency a priority for your portfolio? Learn how we can help create an optimized strategy just for you.

1 By harvesting $100,000 in losses, Investor A reduces their taxable gains from $3.66 million to $3.56 million. The new tax calculation would be: 20% of $3.56 million = $712,000 in taxes owed. The tax savings from the $100,000 loss harvested is $20,000 ($732,000 - $712,000).