When planning your investment portfolio, taking taxes into consideration will help you avoid surprises during tax season.
As you take these tips into account, we recommend you consult with a professional tax advisor to determine what's best for your situation.
Read more: Which type of investment account is right for you?
1. Prioritizing tax-advantaged accounts
Where you keep your investments 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. Here are a few examples:
401(k): An employer-based retirement account. Contributions are pre-tax and deducted directly from payroll, which can decrease your taxable income for the year.
Individual Retirement Accounts (IRA): Traditional IRAs can yield the benefit of tax-deductible contributions while Roth IRAs allow for tax-free withdrawals in retirement.
Health Savings Account (HSA): This isn't a retirement account, 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.
529 college savings plan: If you have kids, a 529 could help prepare for college expenses. Contributions to 529 plans aren't tax-deductible for federal taxes, but your investments grow tax deferred, so you can withdraw money for qualified higher education expenses tax-free.
2. Harvesting your losses in taxable accounts
Tax-loss harvesting can potentially help to minimize what you owe in capital gains tax for investments held in a self-directed brokerage account. The idea is simple: You sell off investments at a capital loss to balance out capital gains.
Tax-loss harvesting can be done at any time but is 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 you don’t have to worry about landing in hot water with the IRS.
3. Calculating capital gains
With taxable accounts, 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. See the IRS website for short- and long-term capital gains tax rates.
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.
4. Knowing 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)
Proper planning could mean fewer tax surprises
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. Consider reviewing your holdings with a tax professional, so you’re less likely to wind up with a surprise when the tax deadline rolls around.
