If you have investments, you might be paying Uncle Sam more than you need to come tax time. Thankfully, there are three things you can do to help keep more of your money in your own pocket. Many investors may not know these strategies are available, or may have heard about them but do not use them.
If while you’re reading this you start to think that these strategies are difficult to implement, you’re not wrong. Before we get started, it’s important to note that when you’re a Betterment customer, we can do these things for you (all you have to do is opt-in through your account).
Now, onto the good stuff: Let’s demystify these three powerful strategies.
1. Tax loss harvest.
Tax loss harvesting can lower your tax bill by “harvesting” investment losses for tax reporting purposes while keeping you fully invested.
When selling an investment that has increased in value, you will owe taxes on the gains, known as capital gains tax. Fortunately, the tax code considers your gains and losses across all your investments together when assessing capital gains tax, which means that any losses (even in other investments) will reduce your gains and your tax bill. In fact, if losses outpace gains in a tax year you can eliminate your capital gains bill entirely. Any losses leftover can be used to reduce your taxable income by up to $3,000. Finally, any losses not used in the current tax year can be carried over indefinitely to reduce capital gains and taxable income in subsequent years.
How do I do it? For example, sell Coke, buy Pepsi.
When an investment drops below its initial value—something that is very likely to happen to even the best investment at some point during your investment horizon—you sell that investment to realize a loss for tax purposes and buy a related investment to maintain your market exposure.
Ideally, you would buy back the same investment you just sold. After all, you still think it’s a good investment. However, IRS rules prevent you from recognizing the tax loss if you buy back the same investment within 30 days of the sale. So, in order to keep your overall investment exposure, you buy a related but different investment. Think of selling Coke stock and then buying Pepsi stock.
Here’s an example of tax loss harvesting:
Overall, tax loss harvesting can help lower your tax bill by recognizing losses while keeping your overall market exposure. At Betterment, all you have to do is see if it’s right for you and turn on Tax Loss Harvesting+ in your account.
2. Asset locate.
Asset location is a strategy where you put your most tax-inefficient investments (usually bonds) into a tax-efficient account (IRA or 401k) while maintaining your overall portfolio mix.
For example, an investor may be saving for retirement in both an IRA and taxable account and has an overall portfolio mix of 60% stocks and 40% bonds. Instead of holding a 60/40 mix in both accounts, an investor using an asset location strategy would put tax-inefficient bonds in the IRA and put more tax-efficient stocks in the taxable account.
In doing so, interest income from bonds, which is normally treated as ordinary income and subject to a higher tax rate, is shielded from taxes in the IRA. Meanwhile, qualified dividends from stocks in the taxable account are taxed at a lower rate. The entire portfolio still maintains the 60/40 mix, but the underlying accounts have moved assets between each other to lower the portfolio’s tax burden.
Asset location in action.
3. Use ETFs instead of mutual funds.
Have you ever paid capital gain taxes on a mutual fund that was down over the year? This frustrating situation happens when the fund sells investments inside the fund for a gain, even if the overall fund lost value. IRS rules mandate that the tax on these gains is passed through to the end investor, you.
While the same rule applies to exchange traded funds (ETFs), the ETF fund structure makes such tax bills much less likely. In fact, most of the largest stock ETFs have not passed through any capital gains in over 10 years. In most cases, you can find ETFs with investment strategies that are similar or identical to a mutual fund, often with lower fees.
Following these three strategies can help eliminate or reduce your tax bill, depending on your situation.
At Betterment, we’ve automated these and other tax strategies, which means tax loss harvesting and asset location are as easy as clicking a button to enable it. We do the work, and your wallet can stay a little fuller.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.