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. Consider 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. Note that contributions to a Roth 401(k) would be post-tax.
Individual Retirement Account (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): While not a retirement account and typically offered only through employer health care plans, an HSA 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. Harvest your losses in taxable accounts
The idea behind tax-loss harvesting is simple: You sell off investments at a capital loss to balance out capital gains. A capital loss is when you sell a security for less than you bought it, resulting in a loss; a capital gain is when you sell for more than you bought it, resulting in a profit.
Be mindful not to violate the IRS “wash sale rule,” which prohibits you from buying “substantially similar” securities to replace ones you sold when harvesting tax losses. It’s safer to work with an investment advisor who handles tax-loss harvesting for you, so you don’t have to worry about landing in hot water with the IRS.
3. Calculate capital gains
With taxable accounts, you pay capital gains tax any time you sell investments at a profit. 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. Understand dividend income
When you own dividend-paying stocks, you might receive a payment a few times a year (i.e. a portion of a company’s earnings paid to eligible stock owners on a per share basis). That money is usually taxable, though the rate varies depending on whether it’s a qualified or nonqualified (aka ordinary) dividend:
Ordinary dividend is taxed as ordinary income, meaning your regular tax rate.
Qualified dividend is taxed at a lower rate — generally the long-term capital gains tax rate.
If you reinvest dividends through a dividend reinvestment plan (DRIP), you’ll have to pay taxes as though you received the cash. If your DRIP allows you to purchase additional shares at a discounted price, you’ll be taxed the difference between the reinvested cash and the fair market value of the stock.
If you receive dividends in the form of additional stock, they’re typically not taxable until you sell the shares.
5. 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 (usually April 15)
HSA contribution: Tax filing deadline (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.
