Wealthfront, Betterment, and FutureAdvisor now offer
"tax-loss harvesting" as an automatic feature on investment accounts.
As Bloomberg View’s Noah Smith explained Tuesday, tax-loss harvesting is a
complicated method of delaying the tax bill on investment gains. By selling
losing investments now, you can lower this year’s tax bill. But experts
disagree on how much extra return you can squeeze out of tax-loss harvesting
over the long term. Some of it depends on your circumstances. If you’re in a
high tax bracket, it makes sense to lower your tax bill now and pay taxes on
your investment gains in future years. It makes even more sense if you’re
planning to donate your fortune or pass it on to heirs. If you’re in a low tax
bracket, it might not make sense to push your taxable investment gains off, when
tax rates could be higher.
Luckily, there are other ways to lower your taxes while
investing. And these methods don’t ask you to predict the future or rely on
complicated computer algorithms.
Take full advantage
of 401(k)s, IRAs, and other tax breaks
Individual retirement accounts (IRAs) and
workplace 401(k) retirement plans let you invest without thinking
about the tax consequences of every trade you make. Traditional IRAs and
401(k)s defer all taxes until money is withdrawn from the accounts. And any
withdrawals from Roth IRAs and Roth 401(k)s aren’t taxed at all once you turn
59 1/2. A 529 college savings account's benefits are similar to those of Roth
accounts; investment gains are never taxed if they’re used for educational
It often makes sense to take full advantage of these sorts
of accounts before you open a regular, taxable account. In a taxable account,
there’s nowhere to hide from the IRS. All dividends and capital gains will be
taxed as soon as they’re realized.
Hold on to investments
for more than a year
The Internal Revenue Service distinguishes between long-term
capital gains — on investments held for more than a year — and short-term
gains. If you’re a wealthy investor who held on to a stock for more than a year
before selling it, the most you’ll pay is a capital gains tax of 20 percent,
plus a 3.8 percent tax on investment income. If you sell the stock before the
year is up, you’ll pay ordinary income tax rates, which go as high as 39.6
investments in 401(k)s and IRAs first
Some investments will put you in a higher tax bracket by
their very nature. If you own an equity fund and the manager is constantly
buying and selling for short-term gains, you’ll probably end up paying a high
tax rate on those gains each year.
But the tax disadvantages of these investments don’t matter
if they’re held in 401(k)s and IRAs. So it usually makes sense to put
tax-inefficient investments in tax-advantaged accounts first. When your options
for 401(k)s, IRAs or 529 plans are exhausted, it’s best to put more efficient
investments — like most index mutual funds and exchange-traded funds — into
Weigh your withdrawal
When an investor gets to retirement, her nest egg is
often spread across three kinds of accounts: taxable accounts, tax-free
accounts like Roth IRAs, and tax-deferred traditional IRAs and 401(k)s. That
allows several strategies that can end up lowering tax bills, if you choose
carefully when you tap the income.
Planning the right strategy may require an accountant and
some math. But there are obvious moves to consider. In a year when your
income is abnormally low — maybe you’re between jobs, or you just retired and
you’re living off savings — it can make sense to tap a traditional IRA and
convert it to a Roth IRA.
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