How tax-alpha is your financial advisor’s advice?


You may have heard about the concept of "alpha," which essentially is the extra bit of performance, for example, a stock manager can generate through skill, on top of ordinary market returns. Tax alpha, on the other hand, is a fancy word, but a rather simple notion regarding the after-tax benefit from implementing tax-smart strategies. Perhaps stated more simply, tax efficiency is a measure of how much of an investment’s return is left over after taxes are paid. 

Regrettably, too many financial advisors and investors do not fully appreciate the hindrance on returns caused by taxes. To the contrary, client-centric financial advisors can be worth their weight in gold by assisting clients to construct a tax-efficient investment portfolio. A 2015 survey of U.S. financial advisors conducted by global asset manager Russell Investments found that fewer than one in five advisors (19 percent) implement tax-loss harvesting, or the practice of selling securities at a loss to offset taxes on capital gains. This tax-efficient strategy is one of the easiest and most effective ways to reduce client taxes now, yet most advisors do not attempt to harvest client losses.

In fact, the value of implementing tax efficient strategies could far exceed a client’s annual advisory fee! I often explain to less experienced financial advisors that great client service costs almost nothing. In other words, employing tax efficient tactics for clients is a great client service that costs virtually nothing!  

Speaking of cost, arguably the best feature of engaging a tax efficient investment approach, such as tax loss harvesting, gain deferral, clever asset location and intelligent withdrawal strategies, is it should cost you nothing! Therefore, it begs the question: If it does not cost the financial advisor or client anything to implement tax efficient strategies, why is this critical methodology of managing money not executed as normal procedure in an investment planning practice?  

I put forth that since there is no immediate monetary compensation for the advisor to implement such tactics, there is little to no motivation to do so, especially since many clients are not aware that these vital tax planning approaches are available in the first place! Go ahead: I will give you a minute to “unpretzel” your brain while you read that last sentence again.

When potential clients engage with our complimentary second opinion service, I often show them how they are leaving money on the table by not incorporating rather simple and straightforward tax efficient tactics. Said differently, these folks are paying more taxes than necessary.

I suggest that all of us, advisors and clients, should look at all financial decisions through the lens of maximizing one’s after-tax returns. Of course, we do not want to be penny wise and dollar foolish. In other words, we should not allow the tax tail to wag the dog. Nevertheless, it is paramount that we, as financial advisors, help encourage clients to transition to a lower-cost, more tax-efficient portfolio. Although, one would think that a CPA would be the safety net for clients regarding identifying more tax efficient investing approaches. Yep, another comforting fantasy but not reality, as some of these bean counters often disregard this critical aspect of investment planning. 

In the final analysis, there is often a substantial difference between our portfolio's pre-tax performance and its after-tax performance, and if we take an active approach to tax management as part of our investment strategy, we may be able to reap significant rewards over the long-term. 

The takeaway message is simple: Ask your advisor to explain to you how he or she is utilizing various tax-smart strategies, such as tax loss harvesting, to help reduce the amount of taxes that your Uncle Sam takes from you. If you want to pay less, that should be your financial advisor and CPA’s business. Perhaps an advertisement that I recently saw said it best, "You must pay taxes. But there’s no law that says you gotta leave a tip."