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, 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 Traditional IRAs and 401(k)s defer all taxes until money is withdrawn from the accounts.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 59 1/2. 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.