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Do you plan for taxes or react to them? Considerations when investing

What we'll cover

  • Tips to help you stay on top of your investment tax planning game

  • How to prioritize tax-advantaged accounts, harvest losses, calculate capital gains and knowing tax deadlines

  • Proper planning could mean fewer tax surprises

Surprises. Some people love them. Others hate them. Regardless of which way you lean, the last place you want to be surprised is in your wallet. But that could easily happen if you're not planning ahead for the taxes you may owe on your investments. Whether you’re a fan or foe of surprises, these suggestions will help you with your investment tax planning game.

As you take these considerations into account, we recommend you consult with a professional tax advisor to determine what's best for your situation.

Prioritize tax-advantaged accounts.

Where you keep your investments – also known as asset location – matters for tax planning. Certain types of accounts are more tax-efficient than others, so it could make sense to focus on funding those first.

For example, the money you put into a 401(k) at work is tax-deductible. The more you put in, the more you could shrink your taxable income for the year.

If you don't have a 401(k) at work, or you do and you have spare cash to invest, you could fund an Individual Retirement Account (IRA) next. Traditional IRAs can yield the benefit of tax-deductible contributions while Roth IRAs allow for tax-free withdrawals in retirement.

Here's another consideration: If you have a high deductible health plan at work you may be able to open an Health Savings Account (HSA). This isn't a retirement account, per se; it's meant to be used for qualified medical expenses. But it offers a tax benefit trifecta in the form of deductible contributions, tax-deferred growth and tax-free withdrawals when the money is used to pay for health care.

Got kids? Then you could reap some tax benefits by contributing to a 529 college savings plan on their behalf. Contributions to 529 plans aren't tax-deductible for federal taxes, but your investments grow tax deferred. And once your child is ready to head off to college, you can withdraw money for qualified higher education expenses tax-free.

Harvest your losses in taxable accounts.

Trading stocks can have an impact on your tax bill. Tax-loss harvesting can potentially help to minimize what you owe in capital gains tax for investments held in a self-directed brokerage account, such as our Self-Directed Trading account. The idea is simple: You sell off investments at a capital loss to balance out capital gains.

Tax-loss harvesting is something you can do at any time, but it’s often done near the end of the year to prepare for the next year’s tax filing. One thing to watch out for is the wash sale rule. This IRS rule prohibits you from buying “substantially similar” securities to replace ones you sold when harvesting tax losses. If you violate this rule, then you won’t get any of the benefits of harvesting tax losses. An alternative is to look for an investment advisor that handles tax-loss harvesting for you, so don’t have to worry about landing in hot water with the IRS.

Calculate capital gains.

Nontaxable accounts or pre-tax accounts, such as a 401(k) or Traditional IRA, don’t require you to pay taxes until the money is distributed. After you reach age 59 ½, the IRS allows you to make penalty-free withdrawals.

With taxable accounts, on the other hand, you pay capital gains tax any time you sell investments at a profit. That’s because they aren’t specifically designed for retirement investing and are more typically used to invest for short- or long-term goals. How much you pay in taxes when selling investments in a taxable account can depend on how long you hold them. You’ll be responsible for short-term capital gains tax when you sell investments at a profit that you’ve held less than one year, whereas long-term capital gains tax applies to assets held longer than one year.

If you plan to sell off any assets in a taxable account, it’s important to know how much you might owe in capital gains tax. This information can also help you choose which assets to hold in taxable vs. nontaxable accounts. For example, taxable accounts may be a good fit for holding stocks that pay qualified dividends, index mutual funds and  exchange-traded funds  (ETFs) with a low turnover rate if you plan to keep them longer than a year.

Know your tax deadlines.

Lastly, it’s important to know your deadlines for maximizing tax efficiency to avoid unwanted surprises. Here are a few key deadlines to know:

  • 401(k) contribution: December 31

  • Tax-loss harvesting for the current tax year: December 31

  • IRA contribution: Tax filing deadline for the following year (usually April 15)*

  • HSA contribution: Tax filing deadline for the following year (usually April 15)*

*Note that the 2021 tax filing deadline has been extended to April 18, 2022, however, the IRA and HSA contribution deadlines are April 15, 2022.

Proper planning could mean fewer tax surprises.

Getting hit with an unexpected tax bill is unpleasant to say the least, but it may be an avoidable scenario. The more time you spend planning for taxes throughout the year, the less likely you are to wind up with a surprise once tax day rolls around. If you’re already investing at work in a 401(k), consider scheduling a review of your holdings with a tax professional. And if you don’t have an IRA or a self-directed trading account yet, you may want to add those to your tax management strategy.

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