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What tax alpha isn’t

Tax alpha is not a widespread term in Canada, says Rebecca Hett, vice-president of tax, retirement and estate planning at CI Investments in Calgary. So far, it’s achieved much more prominence in the U.S.

But Canadians are familiar with the concept of holistic financial planning. Consider tax alpha one possible component of a comprehensive financial plan.

“It’s an opportunity for an investor to outdo regular market performance using tax savings or tax-advantageous strategies,” Hett says.

Some investors with an elementary understanding of tax alpha believe it to be little more than tax-loss harvesting, Hett says, but the concept goes beyond selling investments at a loss to offset capital gains.

“That’s only one aspect of it,” she says.

“Tax-loss harvesting can lead to additional returns over time due to tax efficiency, but it’s really best supported when you have volatile markets and are going to be in a tax bracket in the future that is not higher than where you are now.”

Tax alpha, on the other hand, is a strategy you can use regularly throughout life.

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The tax alpha strategy for your investments

The first step in a tax alpha approach is a traditional, early-stage planning task: determining your long-term financial objectives and risk tolerance.

Once the planning stages are complete, your advisors put their understanding of tax law and financial products to work choosing the combination of assets and accounts that will result in tax-efficient investment choices.

Tax alpha portfolios reflect an understanding of how different forms of income are taxed, which funds you should use to pay for which assets, and the role withholding taxes play in your portfolio’s performance.

Let’s say you have a soft spot for actively managed mutual funds. With a tax alpha strategy, your advisors might explain that opting for indexed investments, such as index exchange-traded funds, could be more advantageous from a tax perspective because ETFs generally have less turnover in their asset mix. Lower turnover can minimize capital gains distributions, which can lead to improved after-tax performance and tax efficiency in the long term.

Because tax alpha investing can be a complex process that encompasses the entirety of your finances, strategizing should involve your accountant or tax advisor, your investment advisor and, when estate planning enters the picture, your lawyer.

But Hett says some Canadians, those with an understanding of tax law who have the time and inclination to do their own fastidious bookkeeping, may have the tools to make tax alpha a reality for themselves.

“I think a lot of astute Canadians can take tax alpha a long way themselves,” she says.

“But when you’re starting to deal with more sophisticated aspects of it, such as tax-loss harvesting or understanding the nuances between different types of investment strategies when you’re dealing with fund structures, I think the financial advisor has a significant role to play.”

But tax alpha does have its more straightforward aspects, such as consolidating investments and simplifying your financial affairs so they’re easier to track.

What’s the potential payoff?

Because tax alpha will mean a different set of strategies for every investor, it’s impossible to put a dollar figure on how much the average person might be able to trim from taxes owed.

And Jason Pereira, partner and senior financial consultant at Woodgate Financial in Toronto, cautions that while tax alpha is a good idea in theory, it doesn’t always result in benefits for every investor.

“The idea is that you locate certain investments with certain types of income in certain accounts to minimize tax,” he says. “The problem is, the optimal allocation is highly sensitive to assumptions on future returns, and since we can't know the future, the result can end up being either positive or negative.”

If slight deviations in assumptions wind up triggering radical differences in asset allocation, Pereira says, tax alpha “becomes impractical.”

However, Hett says investors will be better off if they make the effort to lower their taxes without having to pay additional professional, advisory or market execution fees.

“You’re always going to come out better when you are making smart decisions from a tax perspective.”

She describes the bottom line: “You see claims in the market that tax alpha can increase returns by 1% a year, maybe a bit north of that. What really that comes down to is volatility in the market and the tax bracket that the investor is in, both when they’re executing the strategy and when they anticipate realizing tax that they may have deferred,” Hett says.

One to 2%? Is all that work even worth it?

“Absolutely,” Hett says.

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