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expert's podium

Investors are always on the lookout for "alpha." That is, the extra returns added by management skill above and beyond the returns of the market itself.

Since the onset of the Great Recession, the search for alpha has become urgent, as fixed-income investors lament a low-interest rate environment and equity investors lament sluggish economic growth.

One of the ways the wealthy are dealing with this problem is by getting serious about generating alpha through tax planning. Or, in other words, by paying attention to the additional after-tax, net return they can capture by implementing specific tax minimization strategies. Given how governments are requiring to maximize the amount of taxes they collect to help deal with deficit issues, I foresee the potential for rising tax rates over the coming decade. So all investors, not just the uber-wealthy, should be increasing their focus on ensuring they are optimizing their investment portfolios. The sooner, the better.

Over the past year, I've seen high-net-worth individuals focus more intently on tax alpha as a way of boosting overall returns. The idea being that it's often easier to boost returns by minimizing taxes than it is by picking the right stocks (in this market, I would say considerably easier).

Think about it: taxes are by and large within the realm of your control. If you want to pay less tax, you can often take specific actions or make specific decisions that will result in a lower tax bill. You can't always do that with your portfolio – you're at the mercy of much larger forces. Even if you're a top-notch stock picker (say, like Warren Buffett) you're only going to be able to add equity alpha 60 per cent of the time.

In my experience, it's usually possible to add 1-2 per cent in net portfolio performance by paying attention to taxation strategies. That's a considerable boost, particularly in times when market performance is unpredictable or downright difficult.

Let me be absolutely clear: when I talk about tax alpha, I'm not talking about one-time, reactive decisions such as a last-minute charitable contribution or setting up a spousal RRSP. Nor am I talking about secret Swiss bank accounts, charitable donation credits, and other Hollywood clichés. Most of the high-net-worth individuals I've met are completely uninterested in tax schemes that are complicated, opaque, or have a whiff of questionability about them. They're too smart to fall for that stuff, and you should be too.

Instead, what I'm talking about is a concentrated and co-ordinated effort to organize one's affairs for the expressed purpose of minimizing tax with your investments. I say "concentrated" because minimizing tax becomes a primary focus of your financial decision-making, and "co-ordinated" because the effort takes place across multiple aspects of your financial affairs. The goal of a tax alpha strategy is not to save you a couple of bucks in April. Rather, it's to produce significant, long-term tax savings over several years, if not decades.

Tax alpha takes place on two levels: (a) Structural level – organizing financial affairs to minimize the amount of income lost to tax; (b) Portfolio level – making specific investment decisions that minimize the amount of investment returns lost to tax, or unaffectionately called "tax frictional costs."

Giving you a full list of actionable ideas on each of these levels would take much more room than I have here. I'll be exploring some of these ideas in further detail in the future, but for now, I'd like to give you an overview of some of the more common strategies I see the wealthy using, along with a brief rationale for why they're using them.

I realize not all of these strategies will make sense for all readers. I offer them in the spirit of getting a conversation started with your investment and tax professionals, and as a starting point for further investigations of how tax alpha can make a big difference to your bottom line. In most cases, we are seeing wealthy investors save or defer significant taxes every year, and this will help make up for some of the lower returns expected from the equity and bond markets over time.

Structural strategies:

Holding companies - a particularly attractive structure for splitting income among family members. Very popular with business owners and ex-owners, because it allows for the payment of tax-advantaged dividends to owners and their adult children.

Family trusts – an effective way to add structural tax alpha for almost anyone, regardless of net worth. Properly set up family trusts allow you to move income from family members in a high tax bracket to those in a low tax bracket.

Spousal trusts – offer significant tax savings for surviving spouses living off the income of assets within the trust. For those with sizeable estates, this can defer thousands of dollars of tax.

Investment strategies:

Corporate Class Funds – corporate class funds allow investors to minimize taxes on distributions, and also on dispositions when you switch between funds within the fund family (say, between an international equity fund and a bond fund). Investors with more sizeable accounts can often negotiate lower fees, bringing MERs much closer to those of ETFs.

Dividends – Real "tax planning 101"-type advice here. By emphasizing dividends (which receive preferential tax treatment) over interest-producing investments (which don't), you can save yourself a great deal of tax. The wealthy have continued shifting their portfolio allocations over the past several years to take advantage of these rules.

"Return of Capital" structured investments – a way to receive regular income without being taxed as regular income. Closed-end funds are an example that most any investor can use–although admittedly, not all CEFs use such payments in a shareholder friendly way. Make sure to do your homework if you're interested. It should be worthwhile.