Did you get a surprise when you filed your taxes this year? It’s common for taxpayers to be caught off guard – either owing more than anticipated or receiving an unexpected refund. Though most taxpayers are relieved once taxes are filed, many have little understanding about how to manage their tax situation to enhance their savings and investment strategies.
Many find the process of managing taxes too daunting and simply react to taxes resulting from savings and investment decisions, rather than implementing strategies to minimize their taxes beforehand.
In 2020, many investors overreacted during the pandemic and, fearing market volatility would erase investment gains, sold appreciated investments, subjecting them to increased taxes. Others sold assets in 2021 and taxes incurred because they suspected a proposed tax increase would push capital gains rates from 20% into tax rates of 37% or more, though ultimately there wasn’t political support to pass such tax increases.
To avoid these types of reactive, knee-jerk approaches to decisions, you need a comprehensive tax strategy in place. Once equipped with appropriate strategies – such as those outlined below – taxpayers can adapt their savings and investment decisions and consider taxes as part of the equation.
Savings and Income Tax Advantages
Planning for taxes is meaningful because they influence other overarching financial decisions, including what we purchase, where we live and work, and when and where we can retire comfortably. Managing taxes effectively requires looking at short-and long-term factors, primarily around savings and spending, investments and legacy planning. Often taxes can be lowered depending how much is saved and what savings vehicles are used. Current income tax rates affect our ability or willingness to save – especially in light of incentives offered by qualified retirement plans. For instance, investing in a 401(k) or an IRA can reduce current taxes and provide tax-deferred investment growth until assets are distributed. Alternatively, a Roth IRA or a Roth 401(k), may result in greater current tax payments but permit tax-free growth and tax-free distributions when funded with after-tax dollars.
Choosing between those alternatives requires looking at the overall situation. An investor in the 24% income tax bracket, for example, who contributes $10,000 to a pre-tax 401(k) plan can save $2,400 in federal taxes, lowering the net overall investment “cost.” A designated Roth 401(k) or Roth IRA, assuming savings at the same $10,000 level, would not provide any current income tax break, but would allow the account owner to later take withdrawals tax-free, provided other parameters are met (eg, five-year account period and/or meeting other restrictions).
Individuals should compare taxes saved through savings deferral at their current tax rate with those rates likely to apply once tax-deferred assets are to be withdrawn. For example, a married couple or individual with a marginal 24% tax rate who expect to be subject to much higher taxes in retirement (current highest marginal tax rates are 37%), caused by income from a pension or from other sources, may want to pay taxes on income now, and invest the after-tax dollars to produce tax-free distributions later to avoid paying taxes at higher rates. Alternatively, those expecting income to level off or be reduced once they withdraw funds may be better off with a tax-deferred 401(k) allowing them to retain current income.
Naturally, the situation can change over time, so tax-saving strategies should be revised as circumstances change.
Managing Taxable Investment Accounts
Effectively managed brokerage accounts and other non-qualified, taxable accounts may incorporate a prudent tax-loss harvesting strategy coordinated by investment and tax advisors. Long-term investors can take advantage of lower capital gains taxes from tax loss harvesting when selling investments to cover current expense and withdrawal needs and particularly when buying and selling investments as part of their long-term investment rebalancing to maintain a desired asset allocation and to keep their portfolio diversified.
Investment rebalancing usually involves selling appreciated assets and purchasing others at more attractive prices to meet their investment objectives. In the process, selling appreciated assets can increase capital gains taxes. As appreciated assets are sold, investors can find opportunities to also consider selling other investments currently valued at less than their purchase cost, which can be due to temporary market volatility or other reasons related to the individual holding(s). Selling assets at a loss enables investors to capture a tax benefit. In effect, it allows them to offset any capital gains incurred from selling the appreciated assets.
Consider, for example, an investor who purchases individual publicly traded stocks. For simplicity, let’s assume 100 shares of a stock were purchased over one year ago at $200 per share (total acquisition price of $20,000) and are sold at a price of $150 per share, (total sales price of $15,000). Ignoring any cost of the sale, it generates a $5,000 long-term capital loss (long-term only when the position was sold after a one-year holding period) which can be used to offset other current year taxable capital gains when other investments are sold at market prices greater than their cost. In situations where total annual losses from all sales exceed gains – eg, there are not sufficient gains to completely offset total losses – up to $3,000 of such loss can be used to offset ordinary income in the current year. To the extent losses exceed $3,000, (by $2,000 in the example), investors can “bank” those excess losses to offset future gains, which can be carried over only until death under the current law and regardless of whether capital gains tax rates increase in the future.
A careful approach to loss harvesting should be guided by tax and investment professionals to avoid mistakes when managing capital gains and repositioning investments. Savvy investors can use volatile market periods to make strategic investment maneuvers, through selling to capture their available losses, and may consider repurchase of the same or similar position (the same position may be acquired only after 30 days to avoid wash sale rules). Complications by way of higher taxes can arise from violating wash sale tax rules that effectively disallow a loss if the same security or securities are repurchased within 30 days across various accounts owned by an investor.
In summary, using a tax-effective strategy that looks through a current and future tax lens can keep your savings and investing decisions on the right path for financial success.
The views expressed within this article are those of the author only and not those of BNY Mellon or any of its subsidiaries or affiliates. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
Senior Wealth Strategist, BNY Mellon Wealth Management
As a Senior Wealth Strategist with BNY Mellon Wealth Management, Kathleen Stewart works closely with wealthy families and their advisors to provide comprehensive wealth planning services. Kathleen focuses on complex financial and estate planning issues impacting wealthy families, key corporate executives and business owners.