In today's volatile market conditions, the last thing investors want is to see their returns further diminished by unnecessary tax liabilities. The average investor loses 1%-2% of their returns to taxes every year—often more than what they pay their financial advisors.
This tax drag can create a significant gap between your investment performance and what actually ends up in your pocket, Range notes. But there's good news: Through strategic tax planning techniques, you can capture what investment professionals call "tax alpha"—additional returns that don't come from taking on more market risk, but from intelligent tax management.
Investors can maximize their tax alpha in several ways. While tax-loss harvesting often delivers the most significant tax benefits, a comprehensive approach incorporates several complementary strategies.
The cornerstone of tax alpha is tax-loss harvesting—a strategy that turns market volatility into tax-saving opportunities. While market fluctuations are inevitable, they create windows where individual investments temporarily decline in value.
How Tax-Loss Harvesting Works:
Most traditional advisors harvest losses once a year or only during major market corrections. However, a more proactive approach involves scanning for these opportunities daily, which research indicates can capture significantly more tax benefits: Research shows that consistent tax loss harvesting alone can add over 1% to annual after-tax returns.
The Direct Indexing Advantage:
For investors seeking to maximize tax-loss harvesting opportunities, direct indexing offers powerful advantages. Instead of purchasing an index ETF, direct indexing involves owning the individual stocks that make up the index. This approach:
For example, in 2023, while the S&P 500 returned over 25%, nearly 70% of individual stocks experienced drawdowns of more than 15% at some point during the year. Each of these individual stock declines represented a tax-loss harvesting opportunity that most traditional ETF investors missed entirely.
Not all investment accounts are created equal from a tax perspective. Asset location involves placing investments in the most tax-advantageous accounts:
By picking the most tax-efficient accounts for each specific type of investment, investors can increase their returns. Research shows this strategy alone can add 0.05% to 0.30% to your annual after-tax returns—an extra $500 to $3,000 every year on a million-dollar portfolio without changing your investment selections.
Certain investment classes offer inherent tax advantages:
Including these types of assets in your portfolio can increase your tax alpha advantage and reduce your tax bill.
Unlike market performance, which no one can predict with certainty, tax efficiency is something you can control and optimize for in your portfolio. Beyond your overall portfolio, tax alpha strategies can be particularly helpful when dealing with equity compensation, which can have serious tax implications based on your timing around vesting, exercising, and sales. Tax alpha strategies can give your portfolio a significant edge that hands-off investing simply can't match.
Research shows that comprehensive tax optimization can increase annual returns by 1%-1.5%. Think about what that means over time: On a million-dollar portfolio, over 20 years, that's an additional $350,000 to $525,000 in wealth. This isn't theoretical—it's real money that otherwise would go to the IRS instead of supporting your retirement, your family, or your legacy.
This story was produced by Range and reviewed and distributed by Stacker.
