In the United States, approximately 33% of households have a taxable investment account – often referred to as a brokerage account – and approximately 50% of households have at least one retirement account, such as an IRA or an employer-sponsored retirement account.
We know that adjusting account types can make it challenging for you to decide which accounts to contribute to or withdraw from at which point in time.
Let’s dive straight in to understand more:
- Which accounts are available and why you can choose them
- Benefits of receiving dividends.
- Betterment has stronger tax-sensitive properties.
How are different investment accounts taxed?
Taxable investment accounts are usually the easiest to set up and have minimal limitations.
Although you can easily contribute and withdraw from the account at any time, there are trade-offs. A taxable account is financed with after-tax dollars and any capital you earn by selling assets, as well as any dividends you receive are taxable on an annual basis.
While there are no income delays such as retirement plans, special tax benefits are available only on taxable accounts such as long-term profits, eligible dividends and reduced rates on municipal bond income.
The main consideration
- You want the option to withdraw at any time without any IRS penalty
- You have already contributed the maximum amount to all tax-exempt retirement accounts.
Traditional accounts include traditional IRAs, traditional 401 (k) s, traditional 403 (b) s, traditional 457 government plans, and traditional thrift savings plans (TSPs).
Traditional investment accounts for retirement are usually financed with pre-tax dollars. The received investment income is suspended from the plan until the time of distribution. Assuming that all contributions are financed with pre-tax dollars, the distributions are fully taxable as general income. For investors under the age of 59.5, there may be an additional 10% early withdrawal penalty if the discount does not apply.
The main consideration
- You expect your tax rate to be lower in retirement than it is now.
- You recognize and accept the possibility of early withdrawal fines.
Includes Roth IRAs, Roth 401 (k) s, Roth 403 (b) s, Roth 457 Governmental Plans, and Roth Thrift Saving Plans (TSPs).
Roth type investment accounts for retirement are always financed with post-tax dollars. Eligible distributions are tax free. For investors under the age of 59.5, there may be a general income tax on earnings and an additional 10% initial withdrawal penalty on earnings if a discount does not apply.
The main consideration
- You expect your tax rate to be higher at the time of retirement from now on.
- You expect your modified consistent gross income (AGI) to be below $ 140k (or $ 208k joint filing).
- You want the option to withdraw contributions without paying taxes.
- You can recognize the possibility of a penalty on earnings withdrawn in advance.
We use your dividends to keep your tax impact as small as possible, regardless of the type of account.
Improve four strategies to help limit your tax impact
1. We use any extra cash to balance your portfolio.
When cash is found in your account মাধ্যমে either through dividends or deposits — we automatically identify how to use the money to help you return to your target weight for each asset class.
Dividends are your share of a company’s income. Not all companies pay dividends, But as a betterment investor, you almost always get something because your money is invested in thousands of companies around the world.
Your dividend is an essential component of our tax-efficient rebalancing process. When you receive dividends in your Betterment account, you’re not only making money as an investor – you’re also getting a quick micro-rebalance of your portfolio that helps keep your tax bill low at the end of the year.
And, when the actual allocation of your portfolio deviates from your target allocation due to market movements, we automatically use an incoming dividend or deposit to buy more shares of the backlog of your portfolio.
This helps the portfolio to get back to its target asset allocation without selling shares. This is a sophisticated financial planning strategy that is traditionally only available for large accounts, but our automation makes it possible to do this with accounts of any size.
Aside from dividends, Betterment has a number of features that help you optimize for taxes. Let’s unravel these three powerful strategies.
S&P 500 performance with reinvested dividends
Source: Bloomberg. Performance is provided for exemplary purposes to represent broader market returns for the U.S. stock market. Performance is not responsible for any actual betterment portfolio or it does not reflect a specific betterment performance. As such, it is not a management fee net. The performance of specific US stock market funds in the betterment portfolio will differ from the performance of the broader market returns reflected here.
2. Tax loss crop.
Tax Loss Harvesting can reduce your tax bill by “blowing up” investment losses for tax reporting purposes when you fully invest.
When selling an investment that has increased in value, you will have to pay tax on profits, which is known as capital gains tax. Fortunately, when assessing capital gains tax, the tax code considers your profits and losses across all your investments together, which means that any losses (even on other investments) will reduce your profits and your tax bill.
In fact, if the profit is more than the loss in a tax year, you can completely eliminate your capital gain bill. Any remaining losses can be used to reduce your taxable income up to $ 3,000. Finally, any loss not used in the current tax year can be borne indefinitely to reduce capital gains and taxable income in subsequent years.
How do I do that?
When an investment falls below its starting price কিছু something that can happen to the best investment at any time on your investment horizon — you sell that investment for tax purposes and buy a related investment to maintain your market exposure.
Ideally, you will return the same investment you just sold. After all, you still think it’s a good investment. However, if you purchased the same investment return within 30 days of the sale, IRS rules prevent you from acknowledging the tax loss. So, to keep your overall investment exposure, you buy a related but different investment. Consider selling Coke stock and then buying Pepsi stock.
Overall, tax loss harvesting can help reduce your tax bill by acknowledging losses while maintaining your overall market exposure. In Betterment, all you have to do is turn on Tax Loss Harvesting + in your account.
3. Location of assets.
Asset positioning is a strategy where you keep your maximum tax-incompetent investment (usually bonds) in a tax-efficient account (IRA or 401k) while maintaining your overall portfolio mix.
For example, an investor can save for retirement in both IRA and taxable accounts and has an overall portfolio mix of 60% stocks and 40% bonds. Instead of having a 60/40 mix in both accounts, an investor using an asset positioning strategy will hold tax-unsafe bonds in the IRA and more tax-efficient stocks in taxable accounts.
In doing so, interest income from bonds – which is generally considered normal income and is subject to higher tax rates – is tax-exempt from the IRA. Meanwhile, taxable accounts are taxed at a lower rate, capital gains tax rate, instead of the normal income tax rate on eligible dividends from the stock. The entire portfolio still maintains a 60/40 mix, but the underlying accounts have shifted assets to each other to reduce the portfolio tax burden.
Here’s what an asset location looks like:
4. We use ETFs instead of mutual funds.
Have you ever paid capital gains tax on a mutual fund that has been low for more than a year? This frustrating situation occurs when the fund sells investments inside the fund for profit, even if the value of the overall fund is lost. The IRS rules indicate that the tax on these profits is passed through the last investor, you.
Although the same rules apply to Exchange Traded Funds (ETFs), the ETF fund structure greatly reduces the likelihood of such tax bills. In fact, most of the largest stock ETFs have not gone through any capital gains in more than 10 years. In most cases, you can find ETFs with investment strategies that are similar or identical to mutual funds, often with lower fees.
We go the extra mile for your money.
Following these four strategies can help eliminate or reduce your tax bill depending on your situation.
At Betterment, we’ve automated these and other tax strategies, which means collecting tax losses and locating assets is as easy as clicking a button to enable it. We work, and your wallet can be a little full.
Learn more about how Betterment can help you maximize your after-tax return.