Are higher capital-gains taxes just around the corner? It’s a hot topic of discussion right now in light of the Biden administration’s American Families Plan. The proposed legislation would raise long-term capital-gain and qualified-dividend taxes for some very high-earning individuals (more than $1 million in taxable income) from the current rate of 23.8% to 39.6% (43.4% counting net investment income tax). Whether or not the proposal (or a modified version) makes it through Congress, the discussion around capital gains is a good catalyst for any investor to examine whether their investment portfolio is being managed in a tax-smart way.
No matter your income level or how much you have invested to date, tax efficiency has a meaningful impact on how much of your income you hold on to, and in turn how much your investments grow over time. With that in mind, here are three tax-smart moves to consider, whether you manage your own portfolio, invest with a robo adviser, or work with a financial adviser
Take account… of your accounts: Are your investments in the most tax-smart accounts for your individual financial situation? A good rule of thumb is to maximize contributions to tax-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 provides tax-deferred growth until retirement. If your employer offers a matching program, make sure to take advantage of it.
If you’ve maxed out your tax-advantaged retirement accounts and still have more to invest, a good next step is a traditional or Roth IRA. Traditional IRAs take contributions on a pretax basis. 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 either 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 break. In these accounts, capital gains are taxed the year you earn them, so it makes sense to prioritize investments that are taxed at lower rates in these accounts (like savings bonds, individual stocks you plan to hold longer-term, or index funds).
Consider an investment vehicle tuneup: The type of investment vehicle you choose has a meaningful impact on the tax efficiency of your portfolio, particularly when it comes to stocks. Passive index funds (those that track a market index) are more tax-efficient than actively managed funds. ETFs (exchange-traded funds) tend to be more tax-efficient than mutual funds, in part because they do not distribute many capital gains. ETFs that hold dividend-paying stocks or bonds will pay out dividends and interest to shareholders and those payments will be taxed, but they can still generally 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 a significant factor in long-term performance. Small amounts lost today add up to large amounts lost over time. Automated investment portfolios managed by robo advisers often use ETFs instead of mutual funds as their investment vehicle of choice, so digital investors are often already ahead of the game on the tax front, if you’re investing in a taxable brokerage account. If you work with a traditional financial adviser, ask why they selected the types of funds in your portfolio and whether they are the most tax-friendly options for you. If you manage your own investments, consider whether passive indexed ETFs might be a more tax-friendly alternative to some of your current funds.
Find the silver lining in losing investments: Losing money on an investment never feels good, but losses can work to your advantage through a process called tax-loss harvesting. By selling an investment that is underperforming in a taxable brokerage account, you can use that loss to reduce your taxable capital gains. Additionally, if you realize more losses than gains in a given year, you can use the excess losses to offset up to $3,000 of your ordinary taxable income. Any leftover losses can be carried forward and used to offset income in tax years ahead.
Tax-loss harvesting does not eliminate tax liabilities (you will have to pay taxes on the new stock you bought if you eventually sell it), but it offers a way to defer and reduce current tax liabilities.
Tax-loss harvesting can be a highly proactive activity with losses harvested in reaction to market volatility, or it can be done on a more periodic basis (e.g., quarterly or annually). It’s an involved process and can be time-consuming to do yourself, but it is possible if you are invested (no pun intended) in actively managing your portfolio. If you have an adviser, ask about their approach to tax-loss harvesting. If you use a robo adviser, there are several that offer automated tax-loss harvesting capabilities.
Incorporating tax-smart practices into your investment strategy is worthwhile to avoid an unnecessary tax drag on your returns. That said, avoiding taxes should not be the sole reason for making changes to your portfolio. Your overarching goals and risk tolerance should always be the North Star in determining how you invest.
By combining tax efficiency with clear goals and a solid plan, you can be in a good position to navigate your financial journey no matter where tax policies go in the future.
Amy Richardson is a Certified Financial Planner professional with Schwab Intelligent Portfolios Premium.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.
Investment returns will fluctuate and are subject to market volatility, so that 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 ETF are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
Diversification asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
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