If you’re interested in earning dependable positive returns that you can actually manufacture yourself, there is something you need to write at the top of your to-do list.

Alpha is the excess return that an actively managed mutual fund or portfolio delivers above its referenced benchmark index due to it’s manager’s skill in generating a greater return than expected for the risk taken.

Alpha, an investment geek’s word for outperformance, has become the Holy Grail of investing, yet we also know that excess alpha requires excess beta (risk) and active fund managers kind of suck as a group, rarely delivering the grail. (read: Eight More Reasons…)

You probably care deeply about returns, but not necessarily excess alpha. Excess alpha requires you accepting more portfolio risk, but smart investors have learned to BE the market, and create excess alpha without more risk. How? By combining three specific portfolio management strategies to create another kind of alpha…tax alpha.

Three strategies to create intelligent portfolios and tax alpha

  1. Asset Allocation, the optimal balance of asset classes to achieve your financial goals,

  2. Tax-efficient asset management, ensuring that your strategies and holdings are arranged in such a way that they can be owned or sold at the least tax cost, and

  3. Asset Location, a tax reducing strategy that can create tax alpha, by optimally locating investment holdings.

Employing all three of these strategic methods can provide the investor the benefits of a disciplined tax efficient approach to asset management. Strategies such as using tax-deferred accounts like 401(k)s, taking advantage of the tax free features of a ROTH account or tax free municipal bonds, or performing tax-loss harvesting in a taxable equities account are all ways to achieve tax efficiency.

Asset Allocation

The goal of asset allocation is managing portfolio risk, not trying to beat the market by taking excess risk. 

Asset allocation is a goals-based, “risk management first” approach to investing, that depends on the proper weighting of asset classes, such as stocks, bonds, cash, alternatives, and the weighting of sub-asset classes, such as small and large capitalization equities, domestic and global equities, corporate and government bonds, real estate and precious metals, and so forth. (Read: Strategic Asset Allocation)

In and of itself, asset allocation does not necessarily produce the desired tax-alpha, but it provides a solid foundation for the integrated, tax-efficient asset management.

Tax-efficient asset management

In a few words, an investors job is to build wealth with the least possible risk exposure, keep fees low and slash taxes at every turn.

In a few words, an investors job is to build wealth with the least possible risk exposure, keep fees low and slash taxes at every turn.

Passive investing within an asset allocation model checks all of those boxes.

There is an elegant simplicity to using index-based instruments, such as exchange traded funds or index mutual funds. They get the job done in a low cost, tax efficient way by eliminating portfolio turnover (investment geek work for buying and selling, which drives up costs and taxes) and stripping internal expenses to the bone. (Read: Then along came a SPDR)

Asset Location

One of the most overlooked portfolio management strategies involves asset location, where you hold your investments. The same investment, say a common stock, will receive different tax treatments based on the type of account that its held in. 

Consider three scenarios:

Scenario 1: Shares of stock are held in an IRA, and sold for a gain. When removed from the IRA, the gain will be taxed at ordinary income rates.

Scenario 2: Same shares of stock are owned in a regular taxable brokerage account and sold for a gain. The gain will be subject to a short- or long-term capital gains treatment.  

Scenario 3: Same share of stock are held in a ROTH, and sold for a gain. When removed from the ROTH, the gain will not be taxed. It will never be subject to an income tax.

Same stock. Same gain. Three different tax treatments. 

Location, location, location!

Now, let’s go through a similar exercise with a corporate bond.

If the taxable corporate bond was held in an IRA, and generates income, when removed from the IRA the income will be taxed at ordinary income rates, just as it would if the bond were held in a regular taxable account. If sold for a gain, the gain will be taxable at ordinary income rates as well. Therefore, holding a taxable bond in an IRA does not change how the income is ultimately taxed, but the gain on the sale, which would have been taxed at a more preferential capital gains rates, was converted to ordinary taxation just by holding  it in the IRA.

But if that same taxable corporate bond is held in a ROTH, both the income and any gain from a sale will never be taxed. Because the bond is held in a ROTH, it will never be subject to an income tax.

So the lesson is this: Where you hold the security has a great bearing on its being treated preferentially for income taxation.

Some securities should be held in tax deferred accounts like your 401 (k) or IRA or ROTH, while others are better off in taxable accounts.

For instance, as previously discussed, a growth common stock, or even better, a tax- and cost-friendly growth ETF, can be a tax-advantaged investment in a straight taxable account. Why? 

Because if it does not pay dividends its ultimate return will be taxed at long-term capital gains rates if held longer than one year. If held in a taxable brokerage account you can limit the taxes on profits to 0%, 15% or 20% based on your income and filing status in 2018. 

This favorable treatment can only be bested by holding it in a tax-free ROTH. (Read: IRA, You’re Dead to Me!)

But holding the growth stock in a traditional tax-deferred account, like an IRA or 401(k) will convert its tax advantage into a disadvantage because gains will be taxed at ordinary income rates rather than preferential capital gains rates when the gains are distributed. This is simply bass ackwards.

Remember that traditional retirement accounts have a nasty habit of treating your portfolio profits badly by exposing them to ordinary income rates rather than cap gains when they are withdrawn from the account. Stocks will always do better tax wise if they are in brokerage accounts or ROTH accounts.

But what about dividend stocks or bonds, or even better, a tax- and cost-friendly dividend or fixed income ETF? If they were held in taxable brokerage accounts, then the dividends and interest would be taxed at ordinary income rates, but own them in a ROTH, then voila…Tax free tax alpha!

Of course, there are other considerations and combinations, which is why a holistic view and an objectives-based coordinated strategy for the entire portfolio, using the right combination of taxable, tax-deferred and tax-free accounts, must be explored when adding new positions to the mix.

Further on down the line in retirement, when you begin require more appropriate allocations to reduce portfolio risk, or sell-off and draw down assets, location decisions are critical for the most tax-advantaged way to take income.

So what is the optimal location strategy?

Great question. Elusive answer.

Every investor has different financial goals, time frames, risk appetite, liquidity needs and tax considerations to contend with. You will often read about the “typical investor,” yet no such animal exists. 

Your story is your story, and while creating tax alpha should be a cornerstone of your financial wellness program, you must decide how and when to employ it in your portfolio.

A mistake that many investors make is keeping the same mix, i.e, 60% Equity 40% Fixed Income, across all account types. This is a mistake that can be remedied easily, and should be if you want the most tax efficient outcomes.

Are your growth investments in taxable accounts or your ROTH so you can take advantage of favorable capital gains treatment?

Are your income investments, like bonds, REITs and dividend payers, in your traditional IRA, which will be taxed at tomorrows ordinary income tax rates?

If you answered yes to both questions, you are off to a great start. 

The IRS has bestowed upon us 70,000 easy-to-understand pages of tax law, tuling letters and commentary, so location strategies may seem a bit confusing, until you get the hang of it. But rest assured, there is an optimal mix out there waiting for you. By adopting a tax efficient passive make strategy, you will fix your mix with the proper allocation, hold your investments in their appropriate locations, and start earning the tax alpha that you may be missing out on.

Tax alpha is money in the pocket. Are you leaving it on the table?

Never. Lose. Money.

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