It’s no secret that taxes can take one of the biggest bites out of your investment returns. Consequently, it’s important to thoroughly analyze the short- and long-term tax implications of your investment decisions with an eye toward achieving tax alpha, or the added value that comes from implementing strategies that effectively reduce tax burdens on portfolio returns. After all, the lower your tax liability, the more money you get to keep.
When selecting investments and estate planning tools to meet a client’s unique needs and goals, financial advisors will assess the added returns an investment can earn above a particular market benchmark due to a manager’s specific decisions and actions. This is referred to as alpha, which is the metric by which portfolio managers’ performance.
In the same vein, generating tax alpha refers to the ability to optimize investments via active implementation and management of tax-efficient strategies. Achieving this aim on your own is complicated by the very nature of U.S. tax laws, which are comprised of a complex maze of ever-evolving rules and regulations that can change in an instant. Instead, you can engage professional financial advisors with the specialized skills required to help you navigate tax laws and mitigate tax liabilities.
One of the most common practices advisors use to limit investment tax exposure is tax-loss harvesting, which is the process of identifying capital losses you can use to offset taxable capital gains. This may require you to sell investments or other assets that declined in value during the tax year to create the requisite losses, which you can use to not only offset gains and help reduce taxable income but also to potentially put you in a lower tax bracket.
Another method for capturing tax alpha and improving the after-tax rate of return on investments is to balance or rebalance your portfolio, which involves buying and selling assets to help ensure your mix of investments continues to meet your evolving goals and levels of risk. Rebalancing the portfolio brings exposure back to their targeted weights, and the benefit of will depend on the market environment we are in. In short, rebalancing tends to be the most effective when markets are volatile.
Both these strategies call attention to the first steps needed to optimize portfolio tax savings: investment selection and location. Different asset classes and the potential income they generate can come with different tax implications as do the vehicles you use to hold those assets. For example, putting pre-tax money into a 401(k) or individual retirement account (IRA) can yield tax deductions that reduce taxable income in the years of contributions. That money grows and compounds tax-deferred until you reach retirement age when you will be required to pay taxes on required minimum distributions. At that point, however, it is likely you will be in a lower tax bracket with a lower tax rate on amounts you withdraw from those accounts. Conversely, with a Roth IRA, you pay income tax on your contributions and allow that money to grow tax-free with no tax liabilities required on withdrawals.
Building multi-generational wealth involves far more than investing in the right assets, whether they are stocks, mutual funds, bonds or real estate. Maximizing potential returns requires proactive planning centered on your needs and goals while aiming to create tax alpha.
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or email@example.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
Posted on October 17, 2023