Tax-smart accounts

Choosing the right accounts to save and invest in can lead to significant tax savings over time and put more money in your pocket, both today and years down the road. But how do you know which accounts are right for you—and where do you start? 

First, keep in mind that tax-smart accounts are just one part of your overall financial plan. So the basics still apply—like setting up an emergency fund  and paying down your high interest debt

Once those things are in place, here’s what we recommend: 

  • Save enough in your employer retirement plan to get the full match, if your employer offers one. With pre-tax Tooltip contributions, you’ll defer taxes until retirement and reduce your current taxable income.1 With after-tax Tooltip (Roth) contributions, you’ll pay taxes now—but your money grows tax-free and you won’t owe taxes when you withdraw it.2 
  • Take advantage of a Health Savings Account (HSA). If you have an HSA tied to your high-deductible health insurance plan, save there too. HSAs let you make tax-deductible contributions you can withdraw tax-free for qualified medical expenses, now or in retirement. Investments in your HSA also grow tax-free.
  • Max out your tax-advantaged retirement accounts. Or increase contributions 1% – 2% a year until you reach the max. If you’re already contributing the max to your employer plan or don’t have one, consider a traditional or Roth IRA, or both. In some cases, converting a traditional tax-deferred account Tooltip   to a Roth Tooltip  might also make sense.3 
  • Consider a taxable brokerage account to invest even more. There’s no up-front tax break, and capital gains are taxed the year you earn them. But if you hold assets for more than a year, you may qualify for a lower long-term capital gains tax rate. Tax-efficient investments (like certain municipal bonds) may also offer tax benefits. Losses may be deductible. And the IRS won’t restrict contributions, withdrawals, or how you spend the money.

See the difference between a traditional 401(k) and a Roth 401(k).

Is a Roth IRA conversion right for you? Here are four reasons to consider it.  


Tax-efficient investing

Once you have your accounts, your next step is to put appropriate investments into each one to help minimize taxes on your investment growth and income.

In general, investment returns that tend to be taxed at a lower rate (like long-term capital gains) are better suited for taxable accounts. And investment returns that tend to be taxed at a higher rate (like short-term capital gains) are better suited for tax-advantaged accounts.

Here’s where tax-smart investors typically put their investments:

Here’s where tax-smart investors typically put their investments:

  • Taxable brokerage accounts are ideal for:

    • Individual stocks you plan to hold for more than one year
    • Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
    • Stock or mutual funds that pay qualified dividends
    • Municipal bonds, I bonds (savings bonds)
  • Tax-advantaged accounts are ideal for:

    • Individual stocks you plan to hold one year or less
    • Actively managed funds that may generate significant short-term capital gains
    • Taxable bond funds, zero-coupon bonds, inflation-protected bonds, high-yield bond funds
    • Real estate investment trusts


Tax-loss harvesting and wash sales

Every investment won’t be a winner. But you may be able to use investment losses to lower your tax bill by leveraging a strategy called tax-loss harvesting. Tax-loss harvesting has the potential to reduce capital gains you’ve made in the same year by the amount you’ve lost—and offset ordinary income through a deduction of up to $3,000. Any portion of your loss over $3,000 can be carried forward and claimed in future years. 

Here are three more things to keep in mind:

  • Even if you don’t have capital gains, tax-loss harvesting may reduce your taxable income by allowing you to deduct up to $3,000 in losses. 
  • Tax-loss harvesting can only be used with taxable accounts, (like a brokerage), not with tax-deferred accounts (like a 401(k) or IRA).
  • Tax-loss harvesting can trigger the wash-sale rule, which can disqualify you from claiming your loss in the current tax year. This can happen if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale. 

Learn more about how tax-loss harvesting works.


Retirement tax planning

In retirement, the focus of tax planning and tax-efficient investing is likely to shift from minimizing taxes as you grow your money to minimizing taxes as you withdraw money. 

Adhering to tax rules and deadlines—like those for early withdrawals and required minimum distributions ( RMDs Tooltip )—is key. But so is timing and sequencing withdrawals across all of your income sources (retirement accounts, Social Security, nonretirement investments, and others) in a way that allows you to take advantage of tax rules for different types of accounts and investments.

By taking this approach, you’ll diversify both when and how you pay taxes on your savings—which can help you avoid unnecessary taxes and keep more of your money for your goals. 

Learn more about tax diversification and planning for retirement.

See how Social Security benefits are taxed.

 


Gift and estate tax planning

Planning to pass assets or wealth on to loved ones? If so, consider giving the gift during your lifetime. Not only will you get to enjoy the giving, but this strategy may also reduce your taxable estate and reduce or eliminate taxes for your heirs. 

Tax-free giving strategies include:

  • Using the annual gift tax exclusion Tooltip  
  • Using the  lifetime gift and estate tax exemption Tooltip
  • Making direct payments to medical and educational providers on behalf of a loved one

Learn more about gifting and estate tax rules and limits.

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