Are higher capital gains taxes imminent? It is currently a hot topic of discussion in light of the Biden administration’s American Families Plan. The proposed legislation would increase the long-term capital gains and qualifying dividend tax for some high-earning individuals (more than $1 million in taxable income) from the current rate of 23.8% to 39.6% (43.4%, net income). income tax on investments). ). Whether or not the proposal (or a modified version) makes it through Congress, the discussion on capital gains is a good catalyst for any investor to examine whether their investment portfolio is being managed fiscally wisely.
Regardless of your income level or how much you’ve invested to date, tax efficiency has a meaningful impact on how much of your income you retain, and in turn, how much your investments grow over time. With that in mind, here are three tax-savvy steps to consider whether you’re managing your own portfolio, investing with a robo-advisor, or partnering with a financial advisor.
Taking your bills into account: Are your investments in the most tax-efficient accounts for your individual financial situation? A good rule of thumb is to maximize contributions to deferred retirement accounts — such as a 401(k) — as a first step before allocating money to taxable accounts. Investing in these accounts reduces your taxable income and allows for tax-deferred growth until you retire. If your employer offers a matching program, make sure you take advantage of it.
If you’ve maxed out your tax-advantaged retirement accounts and have even more to invest, a good next step is a traditional or Roth IRA. Traditional IRAs take pre-tax contributions. Roth IRAs take after-tax dollars, but you don’t have to pay taxes when you withdraw later (assuming you meet certain conditions). Individuals can invest $6,000 annually in a traditional or Roth IRA ($7,000 if you are 50 or older).
From there, a taxable brokerage account is the place to invest more, but with no upfront tax benefit. On these accounts, capital gains are taxed in the year you earn them, so it makes sense to prioritize investments taxed on these accounts at lower rates (such as savings bonds, individual stocks you want to hold over the longer term, or index funds).
Consider an investment vehicle tune-up: The type of investment vehicle you choose has a meaningful impact on the tax efficiency of your portfolio, especially when it comes to equities. Passive index funds (which track a market index) are more tax-efficient than actively managed funds. ETFs (exchange-traded funds) are typically more tax-efficient than mutual funds, in part because they don’t pay out much capital gains. ETFs that hold dividend-paying stocks or bonds will pay dividends and interest to shareholders, and those payments will be taxed, but they can generally still be more tax efficient than actively managed mutual funds.
Tax efficiency isn’t the only consideration when deciding which type of investment vehicle is right for you, but it is an important factor in long-term performance. Small amounts lost today add up to large amounts lost over time. Automated investment portfolios managed by robo-advisors often use ETFs rather than mutual funds as their preferred investment vehicle, so digital investors are often already tax-leading if you invest in a taxable brokerage account. If you work with a traditional financial advisor, ask why they chose the types of funds in your portfolio and whether this is the most tax-efficient option for you. If you manage your own investments, consider whether passively indexed ETFs could be a more tax-friendly alternative to some of your current funds.
Find the silver lining when losing investments: Losing money on an investment never feels right, but losses can work in your favor through a process of tax loss harvesting. By selling an investment that underperforms in a taxable brokerage account, you can use that loss to reduce your taxable capital gains. In addition, if you incur more losses than gains in any given year, you can use the excess losses to offset up to $3,000 of your ordinary taxable income. Any remaining losses can be carried forward and used to offset the income in future tax years.
Harvesting tax losses doesn’t eliminate tax liabilities (you’ll have to pay taxes on the new inventory you bought when you eventually sell it), but it does provide a way to defer and reduce current tax liabilities.
Tax loss harvesting can be a very proactive activity where losses are harvested in response to market volatility, or it can be done on a more periodic basis (e.g. quarterly or annually). It’s a complicated process and can be time consuming to do yourself, but it’s possible if you invest (no pun intended) in actively managing your portfolio. If you have an advisor, ask about their approach to tax loss harvesting. If you use a robo-advisor, there are several that offer automated tax loss harvesting opportunities.
It’s worth incorporating tax-savvy practices into your investment strategy to avoid an undue tax burden on your returns. That said, avoiding taxes shouldn’t be the only reason to make changes to your portfolio. Your overarching goals and risk tolerance should always be the North Star when determining how you invest.
Combining tax efficiency with clear goals and a solid plan puts you in a good position to navigate your financial journey no matter where tax policy is headed in the future.
Amy Richardson is a certified financial planner professional at Schwab Intelligent Portfolios Premium.
The information here is for general informational purposes only and should not be construed as an individualized recommendation or personal investment advice.
Investment returns will fluctuate and are subject to market volatility so an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which can be higher or lower than the Net Asset Value (NAV).
Asset allocation diversification strategies do not guarantee profits and cannot protect against losses in a declining market.