The rise of "tax alpha" — 5 investing moves to make now

The wonky term "tax alpha" is well on its way to becoming mainstream for investors. Once the domain of wealth advisors and boutique investment managers with a quantitative bent, the phrase refers to the "extra" layer of after-tax profits that can come from making smart moves to minimize tax bills on securities and funds, and across entire portfolios.

Take an investor with a $1 million portfolio that compounds at 7% a year. After 20 years, that stash would be worth $3,869,684.46, including $2,869,684.46 in unrealized capital gains, according to a simplified example from Morgan Stanley.

Now say that same investor pays the 20% long-term capital gains tax each year. Doing so slices into the pie and its ability to grow, which means it lands at a much lower $2,973,571.35 after 20 years. Of that sum, $1,973,571.35 constitutes capital gains.

Now assume the investor waits until year 20 to pay the taxes owed on her investment. By the time she does that, she will have $2,295,747.57 in capital gains on an investment that has reached $3,295,747.57.

"Tax drag as a measure of the effect of paying taxes annually will always be greater than the tax rate when realizing gains frequently; it increases with the investment horizon and with the size of the return," the Wall Street institution wrote in a primer last year on tax alpha.

By waiting until year 20 to pay the taxes, instead of paying them annually, the investor creates $322,176.22 of "tax alpha."

"Clearly, the effects of paying taxes annually are quite damaging to your after-tax result, and any attempt to reduce the tax drag on the portfolio is a worthwhile pursuit," the guide said.

While Morgan Stanley calls the example hypothetical, its basic principle revolves around the concept of deferral, in which it's generally more lucrative to pay taxes later rather than sooner. One big reason why: Kicking the tax can down the road gives the can more time to grow larger.

Scroll through our slideshow for a look at specific moves investors and their financial advisors can make to boost their tax alpha — if they watch out for the pitfalls: