What is Tax Alpha and How Can You Use it to Increase Your Financial Success?

In the investment world, alpha is a measure of how much risk taken in relation to how much return that risk will generate. Tax alpha is getting an additional return based on your tax planning.

One way to get more return is to be smart about taxes. I believe we are going to be in a low-earning environment for the next decade. We know that interest rates are low and stocks are expensive, so minimizing taxes is very important. In retirement, you can be extremely intentional about your taxes. You can also be somewhat intentional even in your working years.

In your retirement phase, you can choose where you pull income from to supplement your Social Security and how’s it taxed. If I go down to the bank and take out 100 dollars, that doesn’t create a 1099 because I’ve already paid the tax on the money at the bank if it’s not in an IRA. But, if I go to my retirement account and pull out 100 dollars, I have to pay the tax on the 100 dollars first. If I sell a stock, I have to pay the long-term capital gains, which is not as bad as pulling money out of the IRA for most people, but it’s certainly not as friendly as having no 1099 and not paying any tax.

Where we take our income from has a dramatic impact on our tax return. How we invest our money impacts our tax return. We don’t have to worry much about tax efficiency of investments inside an IRA, but we absolutely have to worry about the tax efficiency of investments outside an IRA. There should be good planning done for funds outside an IRA and how those investments are taxed.

Tax planning is much more powerful than tax preparation. Tax preparation is what we do every year in the spring with our CPA, but there is only so much the CPA can do when you’ve already got the 1099. Tax planning, by contrast, is looking forward into the future and figuring out how we can keep those numbers off the tax return to begin with.

Before you turn 70-and-a-half and have to start taking minimum distributions, you have a great deal of latitude of planning and even once you’re there, you have some control in terms of not compounding the issue with taking out those minimum distributions. Should you be doing some raw conversion planning before you are 70-and-a-half to limit the impact of those minimum distributions?

As we move forward, tax planning is going to become more and more critical because I believe we are going to be in a low-earning environment for the next 10 years, so you have to be figuring out ways to minimize taxes because a dollar in your pocket is going to stay with you as we head forward.