Financial planners often talk about finding “alpha” for their clients. In technical terms, alpha is the amount by which a portfolio’s return exceeds that of a benchmark, such as Standard & Poor’s 500 stock index. Considering how much the overall stock market has risen recently, finding alpha is a difficult task. Still, there’s another, related objective—tax alpha—that might be within reach.
Tax alpha is the amount by which, through strategic management, the after-tax returns of a portfolio exceed those of a benchmark. The typical strategy for doing that is to reduce the tax you owe on gains from securities sales by selling depreciated stocks and using the losses to offset the taxable gains.
Your ability to find tax alpha could be affected by the tax changes in the American Taxpayer Relief Act (ATRA). Under the new law, long-term capital gains continue to be taxed at a maximum 15% rate for most investors (0% for those in the two lowest income tax brackets), but the maximum rate is boosted to 20% for single filers who have taxable income of more than $400,000 and joint filers above $450,000. These new tax rules took effect at the beginning of 2013. Still, even upper-income investors can continue to use capital losses to offset capital gains, plus up to $3,000 of ordinary income. (Any remaining loss can be carried over to next year.)
Traditionally, investors have waited until the end of the year to harvest tax losses, when they have a good idea of their overall tax picture. But that approach is effective only if you have actual losses to recoup. Thanks to recent market gains, there could be fewer opportunities than usual in December. So it could make sense to realize losses as they occur—for instance, if a market correction depresses prices and gives you a chance to sell some holdings at a loss.
Making the right decisions about what to sell and when to take losses can get complicated, however. One approach compares existing investments to model portfolios to produce a “target portfolio.” Using tools that can compare digital overlays of different portfolios, this can identify potential trades that will maximize tax losses. At the same time, this method aims to replace securities sold at a loss with other holdings that make sense in terms of the management goals for your portfolio. This can result in a target portfolio that’s as diversified as your original portfolio but that has more potential for alpha—particularly that holy grail of tax alpha.
Of course, the quest for tax alpha shouldn’t happen in isolation. Other variables, including your tolerance for risk and the suitability of particular investments for your situation, also will affect your investment strategies and decisions. We can help you find an approach that fits your circumstances.