When investing, the old saying goes, it’s not what you make that really matters – it’s what you get to keep. Enter “tax alpha.”

So what is tax alpha? 

Perhaps the best way to answer that question is to start with a definition of “alpha:” excess return relative to a target index. Generating alpha – i.e., beating the benchmark – is what every active manager aspires to. It’s how they prove their worth.

Tax alpha is a portfolio’s excess return after taxes – it’s active management focused on reducing the friction that taxes impose on returns. Where traditional “tax-efficient” strategies tend to play defense, tax alpha goes more on the offensive for investors by actively seeking to use the tax rules to boost returns.

A number of strategies are available to pursue tax alpha, with most falling into three broad categories:

AVOIDING TAXES – The most obvious way to reduce taxes on investments to steer clear of creating taxable gains in the first place, be it as income or capital appreciation. A low-turnover equity portfolio can be effective by locking in fewer gains and, when selling, by selecting securities that have appreciated the least. On the fixed income side, tax-exempt municipal bonds/muni funds can be free of both federal and state levies.

REDUCING TAXES – If you can’t avoid investment taxes altogether, the next best thing is to reduce the burden. Among the ways this can be done is by holding investments for at least a year so their sale produces long-term capital gains that are taxed at a much lower rate than short-term trading profits. Qualified dividends from stock holdings also get favorable tax treatment.

OFFSETTING GAINS – Even diligently using active strategies to avoid and reduce, a diversified portfolio will most likely generate taxable income and/or capital gains. Those gains, however, can be offset by tax-loss harvesting. While no one invests with the goal of losing money, loss harvesting is a way to extract some positive value from investments that didn’t work out as planned.

Investment strategies that seek to manage tax exposure are important because research shows that taxes can take the single biggest bite out of total returns for investors. 

Those in the highest tax brackets have long been sensitive to tax impact on their portfolio returns, but the potential benefits of tax alpha stand to accrue to investors regardless of where they fit on the tax continuum.