December 5, 2023

The quirky term “tax alpha” is becoming mainstream among investors. Once the domain of wealth advisors and quantitative-inclined boutique investment managers, the term refers to the “extra” layer of after-tax profits that can come from taking smart steps to minimize losses on securities and funds, as well as entire portfolios. tax bill.

Take the example of an investor with a $1 million portfolio growing at 7% CAGR. Based on a simplified example from Morgan Stanley, after 20 years, the deposit would be worth $3,869,684.46, including $2,869,684.46 in unrealized capital gains.

Now assume the same investor pays 20% annual long-term capital gains tax. Doing so cuts into the pie and its ability to grow, which means it’s worth a much lower $2,973,571.35 after 20 years. Of this, USD 1,973,571.35 constituted capital gains.

Now suppose the investor waits until year 20 to pay the taxes owed on his investment. By the time she does so, she will have made a capital gain of $2,295,747.57 on an investment that has reached $3,295,747.57.

“Tax drag, a measure of the effect of paying taxes each year, is always greater than the tax rate when gains are realized frequently; it increases with investment horizons and the size of returns,” the Wall Street Institute wrote in a report. Last Year’s Primer on Tax Alpha.

By waiting until year 20 to pay the taxes instead of paying them each year, the investor created “tax alpha” of $322,176.22.

“Obviously, the impact of paying taxes each year can be quite detrimental to your after-tax results, and any attempt to reduce the tax drag on a portfolio is worthwhile,” the guide says.

While Morgan Stanley calls this example hypothetical, its underlying principles revolve around the concept of deferral, the idea that it is often more profitable to pay taxes later than earlier. One big reason: Taxing cans in the future would give them more time to get bigger.

Scroll through our slideshow to see concrete steps investors and their financial advisors can take to improve their tax alpha — if they heed the pitfalls: