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Tax alpha: Keeping more of what you earn

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. 

 

Victory Capital, Inc. is a Registered Investment Advisor. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. Any opinions, projections or recommendations in this report are subject to change without notice and are not intended as individual investment advice. Not to be used as legal or tax advice.

©2019 Victory Capital Management Inc.

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Consider the investment objectives, risks, charges and expenses of the funds carefully before investing. Download a prospectus or summary prospectus, if available, containing this and other important information for USAA Mutual Funds from www.usaa.com/prospectus, for Victory mutual funds from www.victoryfunds.com, or for VictoryShares and VictoryShares USAA ETFs from www.victorysharesliterature.com. Read it carefully before investing.

Investments involve risk including possible loss of principal. The value of the equity securities in which the fund invest may decline in response to developments affecting individual companies and/or general economic conditions. Dividends are never guaranteed. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty, and greater volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. You may lose money by investing. There are no guarantees the funds will achieve their investment objectives and strategies may be unsuccessful.

Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

ETFs have the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited and often commissions are charged on each trade, and ETFs may trade at a premium or discount to their net asset value. There can be no assurance that an active trading market for shares of an ETFs will develop or be maintained. The ETFs are not actively managed and may be affected by a general decline in market segments related to the Indexes. The ETFs invest in securities included in, the Index, regardless of their investment merits. The performance of the ETFs may diverge from that of the Indexes. 

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

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Victory Capital means Victory Capital Management Inc., the investment manager of the USAA Mutual Funds and VictoryShares USAA ETFs. Victory Mutual Funds and USAA Mutual Funds are distributed by Victory Capital Advisers, Inc. (VCA). VictoryShares ETFs and VictoryShares USAA ETFs are distributed by Foreside Fund Services, LLC (Foreside). VCA and Foreside are members of FINRA and SIPC. Victory Capital Management Inc. (VCM) is the investment adviser to the Victory Mutual Funds, USAA Mutual Funds, VictoryShares ETFs, and VictoryShares USAA ETFs. VCA and VCM are not affiliated with Foreside. USAA is not affiliated with Foreside, VCM, or VCA. USAA and the USAA logos are registered trademarks and the USAA Mutual Funds and USAA Investments logos are trademarks of United Services Automobile Association and are being used by Victory Capital and its affiliates under license.

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