Taxes often signal good news for investors: they\u2019re usually a sign you\u2019re making money. At the same time, taxes can also eat into your returns and reduce the amount of earnings that you get to keep. Fortunately, there\u2019s a lot you can do as an investor to lower your tax bill and invest more tax-efficiently. In this post, we\u2019ll explain seven ways you can minimize the taxes you\u2019ll owe on your investments.<\/p>\n\n\n\n
Index-based ETFs are exchange-traded funds that let you track a broad market index with one investment. They are inherently tax-efficient because they pass on very few earnings (or \u201ctaxable gains\u201d) to investors who own the ETF, even when the value of the ETF is increasing\u2014which, of course, you hope it will over the long run. <\/p>\n\n\n\n
How do index-based ETFs manage this? One, there\u2019s not much change in the companies included in an index from year to year\u2014typically, there\u2019s only about 5-20% turnover<\/a> each year, depending on the index in question. As a result, the ETF manager doesn\u2019t have to sell stock that\u2019s at a gain very often in order to remove it from the ETF\u2019s holdings. And two, ETF issuers can reduce the gains they have to pass along to investors by intelligently realizing investment losses on the individual investments that make up the index.<\/p>\n\n\n\n Long-term investing isn\u2019t just a smart way to take advantage of compounding<\/a>\u2014it\u2019s also more tax-efficient than short-term investing. That\u2019s because your investments are taxed at a much lower rate if you hold them for at least a year and a day, meaning you get to keep more of what you earn. To get this lower tax rate, you need to hold your investments long enough so that your gains will be treated as long-term capital gains, not short-term capital gains. <\/p>\n\n\n\n Long-term capital gains are taxed at a maximum rate of 20%<\/a> at the federal level. By contrast, short-term capital gains are taxed at the same rates as ordinary income (like your paycheck). The top tax rate at the federal level for short-term capital gains is 37% in 2022.<\/a> <\/p>\n\n\n\n You should factor in the rate at which your investments will be taxed when you select an asset allocation. The fancy name for this is \u201casset location,\u201d but it really just means choosing the right investment mix for each type of account you have. For example, if you have a Roth IRA, any withdrawals after age 59 \u00bd that follow IRS rules should be tax-free. Because of this, you might consider holding more investments with less favorable tax treatment in that account than you would in a taxable account. <\/p>\n\n\n\n Asset location can be complicated to figure out on your own, which is why you might prefer to let a service like Wealthfront do it for you. Wealthfront uses what\u2019s known as \u201cdifferentiated asset location\u201d<\/a> in choosing the right mix for your taxable and tax-advantaged accounts. Our software evaluates the way each asset class is taxed, its risk and return profile, and how it balances out other asset classes to pick the mix that\u2019s right for your account and situation.<\/p>\n\n\n\n Rebalancing your portfolio means buying and selling investments to keep your mix of investments (or \u201casset allocation\u201d) from drifting too far away from what you want it to be. In other words, you sell some of the investments that have done well and you buy more of the investments that have performed less well. Rebalancing is important because it ensures your portfolio stays at (or near) your intended level of risk and expected return.<\/p>\n\n\n\n Let\u2019s say you had a portfolio with 60% stocks and 40% bonds, and stocks performed extremely well and bonds did not. Over time, your asset allocation might drift to 70% stocks and 30% bonds. To rebalance your portfolio and get back to your target allocation, you would need to sell some stocks and buy some bonds. <\/p>\n\n\n\n Of course, selling your winners usually means realizing some taxable gains. Fortunately, dividends can help with this. If you hold investments that pay dividends (for investments offered at Wealthfront, this information is readily available if you search here<\/a>), you can use those dividends to rebalance your portfolio by buying investments you need more of. This should reduce the number of investments you need to sell to rebalance your portfolio, and reduce your tax bill as a result. When you invest with Wealthfront, we automatically rebalance your portfolio<\/a> with dividends. <\/p>\n\n\n\n Tax-loss harvesting<\/a> is a strategy that has historically been used by sophisticated, wealthy investors with high-end financial advisors to lower their tax bills. The concept is simple: when an investment declines in value below its purchase price, you sell it, \u201charvest\u201d the loss, and then buy a similar investment that keeps your portfolio at the right level of risk and expected return. Come tax time, you can use the losses you\u2019ve harvested to effectively cancel out other capital gains so you don\u2019t owe taxes on them. No gains? No problem. You can use your harvested losses to offset up to $3,000 of ordinary income (like your salary) each year and carry the rest of the losses forward to a future year.<\/p>\n\n\n\n As you might imagine, tax-loss harvesting can become very time-consuming if you\u2019re doing it manually. Wealthfront\u2019s Tax-Loss Harvesting service automates this process with the ETFs in your portfolio at no extra cost, and because software doesn\u2019t get bored, it can look for losses every day the market is open and find more opportunities to harvest them than a human checking a few times a year is likely to. In 2021, our Tax-Loss Harvesting service<\/a> generated average estimated tax savings worth between 4-9x our annual 0.25% advisory fee for clients who started using the service in a Classic<\/a> or Socially Responsible portfolio<\/a> last year.<\/p>\n\n\n\n If you\u2019re really serious about maximizing your harvested losses, you can use a strategy known as direct indexing. Direct indexing involves holding the individual stocks that make up a given index (rather than an ETF that tracks the index) and conducting tax-loss harvesting with those individual stocks. Individual stocks tend to be more volatile than indexes, so it\u2019s easy to imagine a situation where a broad index might be up but a few individual stocks are down. As a result, you\u2019ll generally get more opportunities to harvest losses with direct indexing than you would with ETF-level tax-loss harvesting. At Wealthfront, we offer our Direct Indexing service<\/a> in all taxable Investment Accounts of at least $100,000 at no extra cost. <\/p>\n\n\n\n Selling investments that have increased in value generates a taxable gain\u2014and that means you\u2019ll probably owe the IRS money. So if you\u2019re moving investments from one platform or institution to another, you can minimize your taxes by incorporating existing investments into your new portfolio whenever possible (instead of selling and realizing a gain, moving your money, then buying the same investments all over again). At Wealthfront, our software automatically incorporates your existing investments<\/a> whenever it can.<\/p>\n\n\n\n If you make a withdrawal from your investment account, you will typically need to sell some investments. To minimize the taxes you\u2019ll owe, don\u2019t just sell investments at random. Instead, consider selling investments that have lost value first\u2014this won\u2019t generate any taxes\u2014followed by investments with relatively small gains, or gains that qualify for long-term capital gains treatment. This can help you minimize the taxes you\u2019ll owe as a result of the withdrawal. When you withdraw from an Investment Account at Wealthfront, our software automatically sells investments to keep you close to your desired asset allocation\u2014and within each asset class, we sell investments tax-efficiently. <\/p>\n\n\n\n If you have a lot of time on your hands, it\u2019s possible to implement most of the tips in this article by yourself. But it probably won\u2019t be fun. When you invest with Wealthfront, we automate all of this for you to help maximize your after-tax returns with no extra effort or extra cost on your part. The following services are all included in Wealthfront\u2019s 0.25% annual advisory fee:<\/p>\n\n\n\n2. Invest for the long term<\/h2>\n\n\n\n
3. Optimize your asset allocation for taxable and tax-advantaged accounts<\/h2>\n\n\n\n
4. Rebalance with dividends<\/h2>\n\n\n\n
5. Harvest your losses<\/h2>\n\n\n\n
Direct indexing<\/h3>\n\n\n\n
6. Incorporate your existing investments when you transfer between accounts<\/h2>\n\n\n\n
7. Keep taxes in mind when you make withdrawals<\/h2>\n\n\n\n
Bonus tip: use a robo-advisor to improve your after-tax returns<\/h2>\n\n\n\n