3 strategies for tax-smart investing

Every dollar saved in taxes is one more you can spend, save, give or leave as a legacy. Where you save, what investments you own and when you trade can have a meaningful impact on your taxable income and after-tax investment returns. Here are three tax-smart strategies you should consider to potentially reduce taxes now or in the future:

1. Take advantage of tax-advantaged accounts

Tax-advantaged accounts, like a 401(k) or IRA, allow your portfolio to grow on a tax-deferred basis, a major benefit when it comes to saving for your goals. Because taxes can significantly impact your portfolio's value, we generally recommend investing through accounts offering tax advantages.

Tax-advantaged accounts for retirement savers:
When it comes to saving for retirement, you have several account options that offer different tax benefits. With traditional retirement accounts, you may be able to deduct your contribution from your taxable income. This can leave you with more money to invest. Roth retirement accounts don't provide an upfront tax benefit, but their distributions are generally tax free. This can give you additional flexibility to manage your taxes in retirement.

Because changes in tax rules can be unpredictable, we generally recommend investing in different account types to diversify your tax treatment. Where you focus your contributions, though, may change over time depending on your life stage and tax situation. For example, you may want to consider contributing to a traditional retirement account when you expect your tax rate to be lower in retirement than your current tax rate, whereas you may want to contribute to a Roth account when you expect your tax rate to be higher in retirement. If most of your retirement assets are already in a traditional retirement account and/or you have fewer contribution years remaining, you can convert a portion of your traditional retirement assets to a Roth account. A Roth conversion will cause a taxable event, though, so you'll want to consult your tax professional before making any decisions to convert.

Examples of tax-advantaged accounts¹

¹ Refers to federal income tax
² You may have to meet certain requirements to be eligible to contribute.
³ No income taxes apply to traditional 401(k) contributions. Traditional IRA contributions may be deductible  if your income is below a certain threshold.

Tax-advantaged accounts for education savers:

For education savings, we generally recommend a 529 education savings plan. Although contributions are not deductible for federal income tax purposes, you may be eligible for a deduction from state income taxes depending on your state and the 529 plan you choose. And earnings and distributions used for qualified education expenses are generally tax free. If the beneficiary doesn't need the money for college, you may be able to put the unused 529 funds to another use.

2. Locate your assets strategically

Asset location takes advantage of taxation differences between investments by strategically owning investments in specific account types. This is different from asset allocation. Asset allocation is the mix of asset classes you own across your stock and bond investments, which should be based on your goals, risk tolerance and time horizon. In other words, asset allocation is about what you own, and asset location is about where you own it.

Regardless of tax efficiency, Roth accounts are generally an ideal location for your retirement assets with the highest growth potential. They offer tax-free earnings growth, and you typically want to let them grow as long as possible. But, you'll want to make sure your overall asset allocation across your accounts remains aligned with your goal.

The idea behind asset location is to own your less tax-efficient investments in your tax-deferred and Roth accounts and your more tax-efficient investments in your taxable accounts. This is because your tax-deferred accounts are already subject to your income tax rate regardless of the type of investments you own, and your Roth accounts are generally tax free. Your taxable accounts, on the other hand, will be impacted by the types of investments you own and the frequency of trading, so you may want to limit your ownership of certain types of investments in these accounts.

While asset location can be beneficial, your location strategy shouldn't drive which type of account you're funding. First, determine which account to fund, then decide what types of investments to hold within it. Your investments should also align with your overall asset allocation along with your diversification and liquidity needs. As you and your financial advisor work together to add different account types to your portfolio, use contributions and rebalancing opportunities to "relocate" your assets for greater efficiency.

Asset locations

3. Trade opportunistically within your taxable accounts

While strong investment performance is a good problem to have, capital gains can lead to some unexpected surprises at tax time, especially if you hold active mutual funds in your taxable accounts. Trading opportunistically within your taxable accounts can help lower current and future capital gains taxes.

Avoiding short-term gains
Long-term gains occur when you sell an investment you've held for more than a year. These are generally taxed at a lower tax rate than ordinary income. Short-term gains occur when you sell an investment you've held for one year or less. They're taxed at your (generally higher) ordinary income tax rate. While you generally shouldn't hold an investment simply to avoid taxes, it may make sense to defer the sale of one until it qualifies as a long-term gain.

Tax-loss harvesting
With tax-loss harvesting, you sell securities at a loss to offset capital gains. For example, if you sell an investment with a $10,000 taxable gain, you may be able to sell another investment at a $10,000 loss to fully offset it.

Good candidates for tax-loss harvesting are investments that no longer fit your strategy, have poor investment prospects or can be easily substituted with other investments. That's because investments must meet what's known as the wash-sale rule to qualify for tax-loss harvesting. The wash-sale rule prohibits you from writing off an investment loss if you or your spouse buy a substantially identical investment in the 30 days before or after the sale. One way to potentially avoid a wash sale is to buy an exchange-traded fund (ETF) in the same sector or industry as the stock you sold so that you can maintain similar investment exposure until 30 days have passed.

When harvesting losses, short-term losses offset short-term gains first, while long-term losses offset long-term gains first. Once losses in one category exceed the gains of the same type, you can use them to offset gains for the other category. If your total losses exceed your gains, you may be able to offset up to $3,000 of ordinary income per year and carry over the rest to future tax years. The ability to carry over losses to future years makes tax-loss harvesting a good year-round tax management strategy.

Tax-gains harvesting
When rebalancing or raising cash in your portfolio, we generally recommend selling your investments with losses first (short-term losses, then long-term losses), keeping in mind your target allocation, of course. But there may be times when it makes sense to harvest your gains instead.

If your taxable income is below a certain threshold, your capital gains will be taxed at 0% up until your taxable income exceeds that threshold. In 2024, this threshold is $47,025 for single filers and $94,050 for married couples filing jointly. For example, let's say that you and your spouse file jointly and earn $100,000 in 2024. After taking the standard deduction of $29,200, your taxable income is $70,800. The maximum amount of capital gains that can be taxed at the 0% rate is $94,050, which means you can realize $23,250 in gains without paying any federal income taxes.
 

Example of tax-loss harvesting

Chart description

This chart shows how a couple earning $100,000 in 2024 and filing jointly can realize $23,250 in gains without paying any federal income taxes because, after taking the $29,200 standard deduction, their taxable income is $70,800 – or $23,250 below the $94,050 threshold for taxable capital gains

Another time to consider harvesting gains is when you have capital losses to offset them. Capital losses and 0% capital gains are great opportunities to reduce concentrated positions in your portfolio that have a low cost basis. Even if you don't need to rebalance, it may be beneficial to sell a low-cost-basis position to recognize the gain and then repurchase it. This will increase your cost basis on the investment, which could help reduce future taxable gains.

While tax-loss harvesting can be done year-round, tax-gains harvesting is best done toward year-end when you have a clearer picture of your tax situation for the year. As a result, you should consult your tax professional before harvesting gains.

Capital gains avoidance for mutual funds
Mutual funds often pay a capital gains distribution near year-end. If you own shares of the mutual fund on what's called the record date, you'll receive the capital gains distribution and owe the taxes on it even if you've only owned the fund for a day. This means you could be paying taxes on gains you didn't participate in. Mutual funds publish their capital gains distributions in advance, typically in November or December, along with the record date and how much of the gain is short-term versus long-term. If you are considering buying a mutual fund in a taxable account near year-end, you may want to wait until after the record date to avoid the capital gains distribution, depending on your tax situation and the size of the capital gain distribution. You could also consider a similar fund or a more tax-efficient vehicle such as an ETF instead to remain invested.

And, if you already own mutual funds in your taxable account, you'll want to pay close attention to the record date and amount of capital gains. In certain circumstances, it may make sense to exchange or sell your mutual fund shares to avoid the capital gains distribution, such as when you're holding the mutual fund at a loss or a much smaller gain than the capital gains distribution. That said, if you don't need the proceeds, be sure to find an alternative investment that keeps your portfolio diversified and at an appropriate risk level, so you stay invested in the market and on track to achieve your goals.

Consider an advisory program with active tax management features
You could consider an advisory program that executes some of these strategies for you. These types of programs do the work of managing your portfolio for you while offering potential tax efficiencies.

Partner with your financial advisor
Remember, every dollar you save in taxes is one more you can spend on what is most important to you, so managing taxes is an important part of your financial strategy. Whatever your goals and life stage, your financial advisor can partner with you and your tax professional to design an investing and tax management strategy to meet your specific needs.