Investment & Finance

Capital Gains Taxes Associated with Different Types of Investment Strategies

Richard Sun
December 4, 2023
5 minute read
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Capital Gains Taxes Overview

In a normal trading account, your investments are subject to capital gains taxes, which simply means that as you buy and sell assets, Uncle Sam takes his cut. The capital gains tax rate on assets held for longer than one year (long-term) is 0%, 15%, or 20%, depending on your income level. Capital gains taxes on assets held for less than one year (short-term) correspond to your ordinary income tax bracket and can be as high as 37% for the highest earners. Over time, these taxes can significantly degrade your returns, especially if you’re a heavy trader.

Active investment strategies come with a tax risk.

Active investment strategies seek to actively trade assets in response to market conditions. Active investors look to position their portfolios in such a way that allows them to take advantage of market movements. The majority of professional investors on Wall Street use active investment strategies because of their ability to generate positive alpha.

Although active strategies may seem attractive, there is a tax risk associated with them. If an active investor isn’t careful, their short-term trades may lead to a capital gains tax burden that exceeds the alpha generated by a strategy.

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The case for (and against) passive investment strategies.

The average investor doesn’t possess the knowledge or time necessary to successfully run an active strategy, especially one that is attractive on an after-tax basis. This is why passive strategies have become the norm amongst retail investors. Proponents of passive strategies believe that it’s better to ride the market rather than try to beat it.

This type of strategy can work for many investors, but there are times when it falls short. For example, during turbulent times, passive strategies are subject to the volatility and drawdowns of the market. In 2022, if you had left your money in the S&P 500, you would have lost over 25% – that’s a very big hole to dig yourself out of! The key to building long-term wealth is to minimize your losses during market drawdowns. The only way to do that is by actively managing your risk, not by passively standing by.

alphaAI helps mitigate tax risk associated with actively managed strategies.

At alphaAI, we provide investors with systematic, AI-managed investment strategies. By automating key portfolio management functions such as risk management and downside protection, we help you reduce portfolio drawdowns and volatility.

All of our strategies are designed to generate better returns than comparable passive strategies on both a before and after-tax basis. For example, if a passive strategy is expected to return 10% after tax, then our goal at alphaAI would be to beat 10% after tax while also generating lower portfolio volatility (risk) and positive alpha. Our investment AI does this by making sure every trade is optimized from both a pre- and post-tax perspective.

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