Taxes are inevitable. But a number of new online investment firms, or "robo-advisers," are touting a method of chipping away at your tax burden.
Wealthfront, Betterment, and FutureAdvisor now offer "tax-loss harvesting" as an automatic feature on investment accounts. Charles Schwab does, too, on its new, automated Intelligent Porfolios advisory service.
As Bloomberg View’s Noah Smith explained Tuesday, April 21, 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.
And if all that gives you a headache? Welcome to the world of tax law.
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 Traditional IRAs and 401(k)s defer all taxes until money is withdrawn from the accounts.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 59½. 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 expenses.
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 percent.
Put tax-inefficient 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. Also inefficient for tax purposes are high-yield corporate bonds, real estate, and real estate investment trusts, or REITs.
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—such as most index mutual funds and exchange-traded funds—into taxable accounts.
Meanwhile, some investments really make sense only in a taxable account. Municipal bonds, for example, pay out relatively low interest rates—it’s often barely enough to beat inflation. But that interest income is often exempt from federal tax. If you hold a muni bond fund in an 401(k) or IRA, you're not taking advantage of the investment’s main appeal.
Weigh your withdrawal strategies
When an investor gets to retirement, her nest egg is often spread across three kinds of accounts: taxable accounts, tax-free accounts such as Roth IRAs, and traditional tax-deferred 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.
According to a new paper in the Financial Analysts Journal, the most tax-efficient strategy can make a portfolio last six years longer than an inefficient strategy would.