How To Plan Your Taxes When Investing
Tax planning should happen year round. Here are some smart moves to consider that can help you save money now—and for years to come.
Editor’s note: We’re about to dish on taxes and investing in length, but please keep in mind Betterment isn’t a tax advisor, nor should any information here be considered tax advice. Please consult a tax professional for advice on your specific situation.
In 1 minute
No one wants to pay more taxes than they have to. But as an investor, it’s not always clear how your choices change what you may ultimately owe to the IRS. Consider these strategies that can help reduce your taxes, giving you more to spend or invest as you see fit.
- Max out retirement accounts: The more you invest in your IRA and/or 401(k), the more tax benefits you receive. So contribute as much as you’re able to.
- Consider tax loss harvesting: When your investments lose value, you have the opportunity to reduce your tax bill. Selling depreciated assets lets you deduct the loss to offset other investment gains or decrease your taxable income. You can do this for up to $3,000 worth of losses every year, and additional losses can count toward future years.
- Rebalance your portfolio with cash flows: To avoid realizing gains before you may need to, try to rebalance your portfolio without selling any existing investments. Instead, use cash flows, including new deposits and dividends, to adjust your portfolio’s allocation.
- Consider a Roth conversion: You can convert all or some of traditional IRA into a Roth IRA at any income level and at any time. You’ll pay taxes upfront, but when you retire, your withdrawals are tax free. It’s worth noting that doing so is a permanent change, and it isn’t right for everyone. We recommend consulting a qualified tax advisor before making the decision.
- Invest your tax refund: Tax refunds can feel like pleasant surprises, but in reality they represent a missed opportunity. In practice, they mean you’ve been overpaying Uncle Sam throughout the year, and only now are you getting your money back. If you can, make up for this lost time by investing your refund right away.
- Donate to charity: Giving to causes you care about provides tax benefits. Donate in the form of appreciated investments instead of cash, and your tax-deductible donation can also help you avoid paying taxes on capital gains.
In 5 minutes
Taxes are complicated. It’s no wonder so many people dread tax season. But if you only think about them at the start of the year or when you look at your paycheck, you could be missing out. As an investor, you can save a lot more in taxes by being strategic with your investments throughout the year.
In this guide, we’ll:
- Explain how you can save on taxes with strategic investing
- Examine specific tips for tax optimization
- Consider streamlining the process via automation
Max out retirement accounts every year
Retirement accounts such as IRAs and 401(k)s come with tax benefits. The more you contribute to them, the more of those benefits you enjoy. Depending on your financial situation, it may be worth maxing them out every year.
The tax advantages of 401(k)s and IRAs come in two flavors: Roth and traditional. Contributions to Roth accounts are made with post-tax dollars, meaning Uncle Sam has already taken a cut. Contributions to traditional accounts, on the other hand, are usually made with pre-tax dollars. These two options effectively determine whether you pay taxes on this money now or later.
So, which is better, Roth or Traditional?
The answer depends on how much money you expect to live on during retirement. If you think you’ll be in a higher tax bracket when you retire (because you’ll be withdrawing more than you currently make each month), then paying taxes now with a Roth account can keep more in your pocket. But if you expect to be in the same or lower tax bracket when you retire, then pushing your tax bill down the road via a Traditional retirement account may be the better route.
Use tax loss harvesting throughout the year
Some of your assets will decrease in value. That’s part of investing. But tax loss harvesting is designed to allow you to use losses in your taxable (i.e. brokerage) investing accounts to your advantage.
You gain a tax deduction by selling assets at a loss. That deduction can offset other investment gains or decrease your taxable income by up to $3,000 every year. And any losses you don’t use rollover to future years.
Traditionally, you’d harvest these losses at the end of the year as you finalize your deductions. But then you could miss out on other losses throughout the year. Continuously monitoring your portfolio lets you harvest losses as they happen.
This could be complicated to do on your own, but automated tools make it easy. At Betterment, we offer Tax Loss Harvesting+ at no extra cost. Once you determine if Tax Loss Harvesting+ is right for you (Betterment will ask you a few questions to help you determine this), all you have to do is enable it, and this feature looks for opportunities regularly, seeking to help increase your after-tax returns.*
Keep in mind, however, that everyone’s tax situation is different—and Tax Loss Harvesting+ may not be suitable for yours. In general, we don’t recommend it if:
- Your future tax bracket will be higher than your current tax bracket.
- You can currently realize capital gains at a 0% tax rate.
- You’re planning to withdraw a large portion of your taxable assets in the next 12 months.
- You risk causing wash sales due to having substantially identical investments elsewhere.
Rebalance your portfolio with cash flows
As the market ebbs and flows, your portfolio can drift from its target allocation. One way to rebalance your portfolio is by selling assets, but that can cost you in taxes. A more efficient method for rebalancing is to use cash flows like new deposits and dividends you’ve earned. This can help keep your allocation on target while keeping taxes to a minimum.
Betterment can automate this process, automatically monitoring your portfolio for rebalancing opportunities, and efficiently rebalancing your portfolio throughout the year once your account has reached the balance threshold.
Consider getting out of high-cost investments
Sometimes switching to a lower-cost investment firm means having to sell investments, which can trigger taxes. But over time, high-fee investments could cost you more than you’d pay in taxes to move to a lower cost money manager. For example, if selling a fund will cost you $1,000 in taxes, but you will save $500 per year in fees, you can break even in just two years. If you plan to be invested for longer than that, switching can be a savvy investment move.
Consider a Roth conversion
The IRS limits who can contribute to a Roth IRA based on income. But there’s no income limit for converting your traditional IRA into a Roth IRA. It’s not for everyone, and it does come with some potential pitfalls, but you have good reasons to consider it. A Roth conversion could:
- Lower the taxable portion of the conversion due to after-tax contributions made previously
- Lower your tax rates
- Put you in a lower tax bracket than normal due to retirement or low-income year
- Provide tax-free income in retirement or for a beneficiary
- Provide an opportunity to use an AMT (alternative minimum tax) credit carryover
- Provide an opportunity to use an NOL (net operating loss) carryover
If you decide to convert your IRA, don’t wait until December—you’d miss out on 11 months of potential tax-free growth. Generally, the earlier you do your conversion the better.
That said, Roth conversions are permanent, so be certain about your decision before making the change. It’s worth speaking with a qualified tax advisor to determine whether a Roth conversion is right for you.
Invest your tax refund
It might feel nice to receive a tax refund, but it usually means you’ve been overpaying your taxes throughout the year. That’s money you could have been investing! If you get a refund, consider investing it to make up for lost time.
Depending on the size of your refund, you may want to resubmit your Form W-4 to your employer to adjust the amount of taxes withheld from each future paycheck. The IRS offers a Tax Withholding Estimator to help you get your refund closer to $0. Then you could increase your 401(k) contribution by that same amount. You won’t notice a difference in your paycheck, but it can really add up in your retirement account.
Donate to charity
It’s often said that it’s better to give than to receive. This is doubly true when charitable giving provides tax benefits in addition to the feeling of doing good. You can optimize your taxes while supporting your community or giving to causes you care about.
To donate efficiently, consider giving away appreciated investments instead of cash. Then you avoid paying taxes on capital gains, and the gift is still tax deductible. You’ll have to itemize your deductions above the standard deduction, so you may want to consider “bunching” two to five years’ worth of charitable contributions.
Betterment’s Charitable Giving can help streamline the donation process by automatically identifying the most appreciated long-term investments and partnering directly with highly-rated charities across a range of causes.