When someone invests in a stock, their goal is to see a positive return on the investment. Investing in an S&P 500 fund means market returns. In other words, this fund should return the same as the S&P 500 index, the fund’s benchmark.
However, some investors want to do better than a benchmark and expect higher or excess returns. These excess returns are referred to as alpha. Said another way, benchmark returns don’t require any skill, while alpha does.
Can one generate alpha through taxes? What exactly does that mean? That’s the focus of this article. Let’s get some answers.
Just as alpha requires skill and active management of investments, tax alpha also requires the same. This means understanding the tax code and how to squeeze tax efficiency from your investments. The best way to understand what that means is with some examples.
Some investments are tax-sensitive. Meaning you can utilize them for better tax efficiency. These investments have tax flexibility. Investors can use skill (vs. being passive) to take advantage of this tax flexibility.
One way to do this is through long-term capital gains. An investor may have a large profit on a stock and decide to sell it after just a few months of holding, generating a short-term gain in the process. Short-term gains are taxed at the investor’s ordinary income tax rate.
Another investor decides to hold the investment for more than a year, generating a long-term gain. The tax alpha comes from lower taxation of long-term capital gains rates.
Investors can utilize tax loss harvesting to create tax alpha. With this method, investors realize a loss on some investments and a gain on others. The loss offsets some or all of the gain, reducing the total taxable gain.
Here’s an example of how tax loss harvesting works:
Sell 1,000 shares of Stock ABC at $100 with a cost basis of $110, realizing a loss of $10,000.
Sell 1,000 shares of Stock XYZ at $100 with a cost basis of $95, realizing a gain of $5,000.
The net result is a loss of $5,000. $3,000 of this loss can be claimed in the current year, with the remaining $2,000 loss carried into the next year.
A tax loss carried forward can also create tax alpha. This method utilizes losses from the previous year to offset gains in the current year. In the above example, the $2,000 loss was carried forward. So it would be used to offset gains in the current tax year, reducing taxable gains.
Another strategy to generate tax alpha is tax lot management. This strategy sells specific shares of a stock, reducing taxable gain through long-term holdings.
For example, if a client buys MSFT stock on Jan 1, Jul 1, and Dec 31 of 2022, they can sell the Jan 1 shares for a long-term gain. Shares that aren’t over a year old (i.e., Jul 1 and Dec 31) are short-term gains and would continue to be held if the investor wants to generate long-term gains.
There are other methods available to generate tax alpha, including using 1256 futures contracts. These contracts have a tax treatment of 60% long-term gains and 40% short-term, no matter how long the futures contract is held. An investor can sell some of their contracts before one year and still reap the 1256 tax treatment benefits.
Choosing stocks that distribute qualified dividends generates tax alpha. Qualified dividends are taxed at a lower rate than ordinary dividends.
Creating tax alpha can get complex. Every tax filer’s situation is unique. For those reasons, it is best to work with a tax specialist when trying to strategize ways to create tax alpha.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.