What Is Tax Alpha? 5 Ways to Help Boost Returns

How much did your investment portfolio return last year? If you're not accounting for taxes, you may not have the full picture—and could even be leaving money on the table.

That's because a portfolio optimized for tax efficiency can yield, according to one study, an average of 1.98 percentage points annually in additional returns¹—otherwise known as tax alpha. That might not sound like much, but any extra return compounds over time, potentially yielding thousands of incremental investment dollars.

"Your gross returns matter, but more important is what you keep after taxes," says Jeffrey Brown, CFA^®, a client portfolio strategist at Schwab. "Better still, you can generate those extra returns without taking on additional risk."

Here are five ways to generate tax alpha from your taxable brokerage accounts.

This practice involves putting tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts to make the most of available federal tax savings.

A retired couple with a $2 million portfolio—$1 million in a taxable account and $1 million in a tax-advantaged account—could potentially see a sizable reduction in tax drag, depending on their tax bracket, by aligning their assets and accounts.

You can review your portfolio with an eye toward selling losing positions to offset your overall taxable income—a.k.a. tax-loss harvesting. Losses from underperforming investments can reduce your capital gains and potentially offset up to $3,000 of your ordinary income. You can carry forward any losses exceeding that amount to counterbalance realized capital gains and taxable income in future years.

Many investors engage in tax-loss harvesting when they periodically rebalance their portfolios back to their target allocations; however, you can opt for a more sophisticated approach that involves harvesting losses on an ongoing basis, including:

Rather than invest in a fund that tracks a given index, this strategy involves purchasing the individual securities within the index according to your investment objectives. "Direct indexing can allow you to harvest losses and offset gains to a degree not possible with an index or exchange-traded fund," Jeffrey says.

It can also be helpful in reducing concentration risk. For instance, employees who are awarded company stock might use direct indexing to exclude that stock and similar stocks from their portfolio. That said, this strategy typically commands higher management fees and minimums than more traditional index funds.

With this strategy, a fund manager allocates 30% of capital to short positions (expecting to profit from price drops on borrowed securities) and uses the extra capital to invest 130% in long positions (expecting to profit from price gains). In addition to the possibility of higher returns, the strategy can create more opportunities to harvest losses from both long and short positions.

However, 130/30 investing generally involves margin borrowing and leverage, which can amplify any losses. You will also likely need a separately managed account and to factor in management fees, which tend to run higher than those of exchange-traded and mutual funds.

The inopportune sale of an investment or equity award can leave tax savings on the table. For example, gains from the sale of any taxable investment held a year or less are taxed as ordinary income (up to 37%), whereas investments held more than a year are taxed at the lower long-term capital gains rate of 0%, 15%, or 20%, depending on your income.

Conversely, it can sometimes be better to recognize taxes sooner rather than later. One example is taking steps to avoid the "widow's tax," which occurs when a surviving spouse sees a jump in their income tax rate by becoming a single filer in the year after their spouse's death. "Particularly in cases where there is a large age gap between spouses, you may want to consider additional distributions from tax-deferred retirement accounts once you reach age 59½ to take advantage of the larger joint filing tax bracket while both partners are still alive," Hayden says.

Equity compensation is another area that bears timing consideration. Restricted stock units, a type of noncash corporate compensation, are awarded to employees on a predetermined schedule, so there's nothing you can do to avoid the initial tax liability when they vest. Your employer must withhold ordinary income, Social Security, and Medicare taxes from the award and report it on your W-2. However, you can decide when to sell the stock—if you are able to do so—which will result in capital gains or losses, with rates determined by how long you held the shares.

Let's say you have 100 shares that vest when your company stock is valued at $215. This results in $21,500 of taxable income ($215 × 100) that pushes you into a higher tax bracket. In order to decrease your concentration risk—and help cover the difference between the tax withholding required by your employer and the amount you'll likely owe because of your higher tax rate—you sell 20 shares when the stock hits $205 four months later, resulting in a short-term capital loss of $200 [($205 – $215) × 20]. You can then apply this loss to offset other gains.

"Work closely with a CPA when managing executive pay to avoid penalties for underwithholding," says Kevin Trisler, CFP^®, CWS^®, CEP, senior equity compensation planner with Schwab's Wealth Strategies Group. "Also, be aware that exercising stock options or selling shares acquired through an employee stock purchase plan can result in double taxation—once as compensation income and again as capital gain. Providing proper tax documentation to your CPA can help prevent this mistake."

When philanthropy is part of your overall wealth strategy, it can also pay to plan your gifts to maximize their tax benefits.

For example, strategically donating a long-term asset to charity can allow you to deduct its fair market value from your ordinary income, while also eliminating any capital gains you would owe by selling it, which is especially advantageous when it comes to substantially appreciated investments. "Donor-advised funds can be good for this type of giving because the money can stay invested, increasing the amount available to grant, while you decide which charities should benefit and when," says Caleb Lund, director of the Charitable Strategies Group at DAFgiving360^®.

You could also transfer highly appreciated assets to an irrevocable grantor retained annuity trust (GRAT) in return for annuity payments that equal the total value of the assets, plus a fixed rate of return, over a set number of years. At the end of the term, any appreciation of the assets beyond the interest rate is removed from your estate and passes to your heirs or charitable beneficiary without estate or gift taxes.

There are other possibly suitable ways to for generate tax alpha, depending on your financial situation and goals:

These funds can help manage concentrated stock positions without triggering capital gains. You contribute your concentrated shares to a pooled fund of diversified securities and receive a proportional ownership share of the fund. After a holding period of at least seven years, you may redeem your shares and receive a basket of securities; you will pay taxes on gains from those shares only when you sell any of them.

It's important to note that exchange funds may apply liquidity restrictions on your investment via lockup periods and redemption rules before and after the holding period. Additionally, they often have investment minimums, management fees that could impact returns, and limited availability only to investors who meet the fund's qualifying standards—typically those with investable assets of $5 million or more.

Recent legislation made permanent these funds that were established temporarily in 2017 and modified the structure and reporting requirements to reflect this change, which takes effect on January 1, 2027. Generally, investors who channel capital gains into these funds—which invest in low-income "qualified opportunity zones"—can defer and potentially reduce their taxes.

For instance, say you have a capital gain from an investment portfolio or real estate sale; if you invest it within the 180-day post-sale reinvestment period in a QOF, you can defer those gains for up to five years. What's more, if you hold the interest for at least 10 years, you can adjust the basis of the QOF to its fair market value, allowing for tax-free gains on that investment.

In this scenario, you convert your traditional IRA to a Roth IRA and pay income taxes on the converted funds. This could yield tax advantages if you expect your tax bracket to be the same or higher in retirement because qualified withdrawals are entirely tax-free, so long as the account holder is at least 59½ and the account has been open for at least five years.

Also, Roth IRAs aren't subject to required minimum distributions beginning at age 73 or 75, depending on your birth year. However, to help smooth out your tax bill, you may want to consider multiple conversions over several years to avoid pushing yourself into a much higher tax bracket. And remember, each conversion is subject to its own five-year holding period.

"Generally speaking, taxes should not be the primary driver of your investment decisions," Hayden says, "but they can have a significant impact on your net returns, and you can have more control over when you pay them than you may realize."