Tax awareness is important not only because of your legal obligation to file taxes correctly, but also because planning ahead can increase your returns by reducing the tax you pay. Diversification is often called the only free lunch in investing, but using tax knowledge to increase your after-tax returns is something close to a free lunch, because you don't have to compete with anyone else for the increase in gains provided by minimizing taxes.
Even if you pay someone to do your tax return, you need to understand the principles detailed below. There are mistakes and suboptimal actions that your accountant cannot fix retroactively. Overcontributing to your IRA or triggering wash sales you didn't intend can lead to needless stress, paperwork, and potential tax penalties (or money otherwise lost). But taxes don't need to be intimidating! They can be straightforward if you equip yourself with basic knowledge and plan ahead.
The information below is general and tax law is very particular. Somewhat different rules apply to you if you derive most of your income from farming or fishing. People with permanent disabilities receive very different tax treatment — these are just two examples. Understanding your own situation is important. If your circumstances might be unusual, research whether they have tax implications.
Click to skip to each section:
- The basics
- The essentials
- Tax-advantaged accounts
- Roth or traditional?
- Tax-efficient investing
- Wash sale rules
- Tax loss harvesting
- Estimated tax payments
- Summary
If you aren't sure you completely understand marginal tax rates, and how a marginal tax rate differs from an average or effective tax rate, go ahead and watch these two brief videos. This is a prerequisite to understanding everything else. A marginal tax rate is the rate at which you pay tax on the next dollar you earn. An effective or average tax rate is the rate at which you pay tax when all dollars are considered.
The difference between a "tax return" and a "tax refund" is commonly misunderstood. Your tax return is the documentation you send to the IRS (and state-level counterparts) each year. Often you'll be owed money and will receive a payment from the IRS. This is not your return; it is your refund. Receiving a large refund may be psychologically rewarding, but it is not a benefit. It simply means that you overpaid taxes and the IRS is refunding the overpayment. The refund you receive, or the payment you make, when you file your taxes is meant to resolve the difference between the amount you already paid and your tax liability. Ideally your refund (or the amount you owe) each year should be small. If it is small, that means the tax you owed was accurately withheld from your paychecks (or otherwise sent to the IRS throughout the year).
Your filing status is an important part of your tax return, and it's partly determined by your marital status on December 31. Most people who are not married are single filers, and most who are married are joint filers. Married people can also file separately, but it generally leads to paying more tax, so the default for married people should be to file jointly. Married filing separately is not the same as the single filing status. Married people cannot choose to be single filers, even if it lowers their tax burden. There are additional, less common filing statuses.
You can claim a dependent on your tax return if you provided more than half of someone's financial and housing support in that year, among other conditions. As you'd expect, the most common dependents are children, but others can be dependents as well. Taxpayers with children can qualify for tax breaks like the child tax credit. An unmarried person can lower their tax bill by filing with the "head of household" status (instead of the single status) if they have a qualifying dependent — a person to whom they provided a majority of financial and housing support.
If I say something about "my 2023 taxes", am I referring to taxes I paid on income earned in 2023, or the tax return I filed in 2023 based on income earned in 2022? The term "tax year" can help avoid ambiguity. Most Americans filed their tax returns for the 2023 tax year in early 2024. They will file returns for the 2024 tax year in early 2025.
Credits and deductions can reduce your taxes, and it's important to know the distinction. A tax credit is a simple reduction of your tax liability. If your federal income tax liability for a given year is $10,000, and you receive a $500 credit, your tax liability is reduced by $500. In contrast, a deduction reduces the amount of income that is subject to tax. For example, the standard deduction in the 2024 tax year for single filers under 65 is $14,600. Taking the standard deduction doesn't reduce your federal tax liability by $14,600. It means that your taxable income is reduced by $14,600, so that amount is not subject to any federal income tax.
Additionally, there are two broad types of tax credits: refundable and nonrefundable. A refundable credit is better: it can not only reduce tax liability to zero, but it can make it negative, resulting in a net payment to the tax filer. A nonrefundable credit can lower your ordinary income tax liability to zero, but cannot reduce it further. People who have low incomes and are eligible for a nonrefundable credit may find that the credit is worth less than they thought, because they owed very little federal income tax in the first place. The earned income credit is a common refundable tax credit. The saver's credit, discussed below, is a nonrefundable credit for low-income filers who contribute to retirement accounts.
Most people will have all the info they need to file their return for the 2024 tax year by mid-February 2025. The return is due by April 15 (or, if April 15 is not a business day, the first business day after April 15). Requesting an extension is a common practice, especially by tax professionals who are doing many returns. If you file electronically, the IRS and state-level agency might quickly approve your return — possibly in less than an hour. If you file a paper return, the IRS backlogs and archaic technology could leave you waiting months for a response.
For the typical taxpayer who wants to do it on their own, I recommend FreeTaxUSA. They're part of the IRS Free File Alliance, so you can file for free if your income is under your state's threshold. And if it's above the threshold, they charge an extremely reasonable $0 for the federal return and $15 for each state return. Although they don't have every streamlined feature that TurboTax does, they make it very easy and their explanations are clear. This article is a good read on how lobbying by Intuit (creator of TurboTax) is almost single-handedly responsible for the absence of free, pre-filled filing software for all Americans. TurboTax and H&R Block have withdrawn from the IRS Free File Alliance.
We'll begin with calculating how much of your income is subject to income tax. Let's say we're a 30-year-old single filer who earned $70,400 from our job in 2024. We also realized $5,000 in capital gains, and adding these two values gives us our gross income of $75,400. We paid $800 in student loan interest in 2024, so we can deduct that from our gross income of $75,400 to give us our adjusted gross income (AGI) of $74,600. AGI is always less than or equal to gross income, because it's calculated by taking certain deductions. Deductions used to calculate AGI are called above the line deductions.[1] After finding their AGI, most people take the standard deduction, because it's preferable to itemizing deductions unless you donate a great deal to charity or pay a lot of tax-deductible interest (among other reasons).[2] The federal standard deduction for income tax in 2024 is $14,600 for single filers and twice that ($29,200) for married people filing jointly. It's slightly expanded for those who are at least 65. So we subtract $14,600 from our AGI, leaving us with a taxable income of $60,000. This is the amount that will be subject to federal income tax.
A central concept is the distinction between short- and long-term capital gains. A long-term gain results from a position that was closed more than a year after it was opened, and the federal government taxes long-term gains at lower rates to encourage investment rather than rapid trading. A short-term gain — arising from a position with a holding period of one year or less — is taxed as ordinary income.
The plot below shows the marginal tax rates for single filers in the 2024 tax year. As you can see, most investors are taxed at a marginal rate of 15% for long-term capital gains but a higher rate for ordinary income. Joint filers have thresholds that are exactly double those of single filers at the low end, as one would expect. However, the thresholds at the high end are disadvantageous for married couples. Joint filers enter the top marginal rate for ordinary income at a threshold only 20% higher than the single filer threshold. The marriage penalty is even greater for capital gains: joint filers enter the top marginal rate at a threshold only 12.5% higher than that of single filers.[3] You can see all rates for ordinary income and capital gains here and here.
Here's another acronym: modified adjusted gross income (MAGI). MAGI is an important variable used to determine income restrictions for certain benefits and applicability of certain taxes, so we'll see it more later. It's calculated by starting with AGI and adding back some deductions, so gross income ≥ MAGI ≥ AGI. It's possible for all three to be equal. Those with a high MAGI may be affected by the net investment income tax (NIIT), which adds a 3.8% tax to investment earnings when MAGI exceeds $200K for single filers and $250K for joint filers. Here are a couple examples: a single filer with $180K of earned income and $40K of net capital gains would pay the extra 3.8% tax on $20K of their net gains, because $20K of net gains exceed the $200K threshold. A single filer with $210K of earned income and $30K of net capital gains would pay the extra 3.8% tax on all of their net gains, because all of their net gains are above the $200K threshold. (We're assuming their MAGI equals their gross income.) This tax means that some people pay an 18.8% marginal rate on long-term gains instead of 15%, and nearly all those in the 20% bracket actually pay 23.8%. The NIIT is levied not only on net capital gains, but also on dividends, interest, rental income, bond coupon payments, and so on.
As you might assume, everyone is taxed according to net investment gains. You'll have up to four categories of gains and losses: short-term gains, short-term losses, long-term gains, and long-term losses. Your short-term gains and losses balance out with each other and, separately, your long-term gains and losses balance out. Only if you realize a net gain in one category and a net loss in the other do they offset one another. A net long-term gain of $5,000 and a net short-term loss of $1,000 would leave you with a tax bill on $4,000 in long-term gains. Any final net loss once the two categories have settled up is the same: it reduces your taxable income, regardless of whether the losses were short-term or long-term.
Deduction from your taxable income due to a net loss has a limit of $3,000 per year (unless you establish trader tax status, which is for very frequent traders). Any net losses that exceed the limit can be deferred to future years. But if losses are carried over, then the distinction between short-term and long-term net losses begins to matter. For instance, if you realized a $4,000 net loss in Year 1 composed entirely of long-term losses, you would deduct $3,000 from your gross income in Year 1. In Year 2, you would have the opportunity to offset $1,000 of capital gains, but the long-term losses would preferentially cancel long-term gains. So net short-term and net long-term losses (or a combination of the two) are meaningfully different outcomes if total net losses exceed $3,000.
Let's say in our example above with $5,000 of capital gains, we realized a net $2,000 in short-term capital gains and a net $3,000 in long-term capital gains in 2024. How much federal income tax will we pay? You can imagine these amounts stacked on each other, with the earned income on the bottom, the net short-term capital gain in the middle, and the net long-term capital gain on top. It's good that the long-term gain is on top because its marginal rate is lower than that of ordinary income for nearly every taxpayer.[4] Because short-term capital gains are taxed as ordinary income, we can merge the earned income and short-term gain into $57,000 of ordinary income. If you like, below everything you can imagine the standard deduction of $14,600, which is taxed at 0%.
We pay 10% on the first $11,600 of taxable income ($1,160), then 12% up to $47,150 ($4,266), then 22% up to $57,000 ($2,167), for a total of $7,593. Our net long-term capital gain of $3K is on top of the imaginary stack of $57K of ordinary income, so it ranges from $57K to $60K. That entire range is higher than $47,025 but less than $518,900, so we pay 15% on all of our long-term gains ($450), for a total of $8,043 of income tax owed. Tax forms round values to the nearest dollar, so some rounding would probably change that final number by a tiny amount. The net investment income tax does not apply because our MAGI of $75,400 is less than $200,000. See above for calculation of our AGI. A common difference between AGI and MAGI is that student loan interest can sometimes be deducted from AGI, but is added back to calculate MAGI.
FICA taxes — short for Federal Insurance Contributions Act taxes — are federal payroll taxes. 6.2% of your paycheck funds Social Security, and an additional 1.45% funds Medicare. These add to 7.65% of all your earned income (unless your income is high). The Social Security tax stops after $168,600 of individual earnings in 2024. But the Medicare tax has no income cap and actually escalates by 0.9% for income above $200K for single filers and $250K for joint filers. The deductions for income tax do not apply to FICA taxes: these taxes start at the first dollar earned. Continuing our example from above: so we need to pay 7.65% on the full earned income of $70,400. This works out to $5,386 in FICA taxes, which were likely withheld from our paycheck throughout the year. FICA taxes do not apply to capital gains or distributions, so we don't pay any more federal tax on our capital gains (including the short-term gain).
That's a total of about $13,429 in federal tax liability. Let's say $13,300 in federal tax was withheld throughout 2024 by our employer, so we owe $129 to the IRS on tax day. Some people would be upset that they didn't receive a refund, but we understand that a refund means providing the IRS with an interest-free loan until it returns our own money to us. If we had really wanted to avoid paying on tax day, we could've paid more tax throughout the year by withholding more through our employer (or sending money directly to the IRS). The section below on estimated payments explains under what conditions you can wait to pay your full tax liability, and how to avoid waiting in a way that would trigger interest or penalty charges.
The main way we could have reduced FICA taxes would have been to contribute to a health savings account (HSA) through our employer's payroll deduction. We could have contributed as much as $4,150 in 2024 and reduced our earned income that was subject to FICA taxes by that amount (or by up to $8,300 for a family insurance plan). An additional $1,000 is allowed for those who are at least 55 years old. Assuming a single plan and age less than 55, maxing out these contributions would have reduced our federal income tax and FICA taxes by $1,230. Contributing $7,000 to a traditional IRA would have reduced our federal income tax by a further $1,540 (with no effect on FICA taxes). These contributions would reduce our AGI by a total of $11,150, from $74,600 to $63,450. Our MAGI of $71,250 would be computed by adding back deductions from the $7,000 IRA contribution and the $800 of student loan interest, but not the HSA contribution. 401(k) contributions could have reduced income tax further, and we would want to prioritize these above IRA contributions if our employer had a matching policy. Unlike traditional IRA contributions, traditional 401(k) contributions are not added back to calculate MAGI. If we wanted to reduce our MAGI — for which potential reasons are discussed below — this could make traditional 401(k) contributions preferable. Depending on the state we work in, these actions could save even more money by reducing state taxes.
The above refers only to federal taxes. State tax policies on capital gains vary; check those for your own state. Most commonly, some states tax all capital gains as ordinary income and some states do not tax capital gains. There are other policies: some states tax short-term and long-term gains at different rates; some states have a distinct rate or rates for all capital gains or have a unique deduction for capital gains.
In the context of taxes, a lot refers to a group of shares purchased in a single transaction. When selling shares of a stock or fund, the FIFO (first in, first out) method is the default. This is because if you purchased shares of the same security on different days, you will automatically sell the lots purchased earliest and, if possible, make use of any long-term capital gains tax rates. You can use a different method of selecting lots to sell if it benefits you — these are called disposal methods.
Dividends, whether reinvested or not, are taxed. This is true of dividends you receive from stocks as well as stock funds. The terms "ex-dividend date" and "qualified dividend" should be understood. Those who own shares at the end of the business day before the ex-dividend date will receive the upcoming dividend payment, regardless of whether they sell some or all of their shares before the payment. Those who buy shares on or after the ex-dividend date will not receive it. (This implies that the value of each share falls by the amount of the dividend on the ex-dividend date.) A dividend you receive is qualified if the security is traded on US exchanges and you owned the shares for at least 60 days during the 121-day window starting 60 days before and ending 60 days after the ex-dividend date.[5] The day you acquired the security does not count toward the 60 day minimum, but the day you disposed of it does. The distinction matters because qualified dividends are taxed as long-term capital gains, whereas ordinary dividends are taxed as short-term gains — ordinary income. When you receive dividends from a fund, you are not in complete control of their tax status. The fund must satisfy the 60-day requirement with respect to its ownership of the shares, and you must satisfy it with respect to your ownership of the fund shares. Nearly all dividends from broad US market index funds tend to be qualified.
Bond funds regularly pay dividends, but these are different than the dividends you receive from stocks and stock funds. They are always taxed as ordinary income. And unlike stock ETFs, bond ETFs may need to distribute capital gains at the end of each year, which will cause you to adjust your short- and long-term capital gains according to the gains or losses realized in the fund. As with stock funds, capital gains or losses derived from selling shares of bond funds count as either short- or long-term capital gains, depending on whether the holding period is more than one year.
Unrealized gains do not apply to taxes: if you buy shares but have not sold any, the gain or loss is not taxable until the shares are sold and it becomes a realized gain or loss. As stated previously, capital gains distributions from mutual funds make their tax burden higher and more complicated than the tax burdens arising from stocks and stock ETFs. Because stock ETFs do not need to distribute capital gains, they should be favored over mutual funds in taxable accounts. Stocks and stock ETFs still have involuntary taxable events when dividend payments occur.
If your income reaches multiple hundreds of thousands of dollars in any year, read up on the alternative minimum tax (AMT), which may increase your federal tax liability (and state tax liability, if your state has an AMT).
Check out this link for the most common tax credits.
In the Guidelines section, the discussion of emergency funds explains how different types of bonds are taxed, and the discussion of renting vs. buying briefly explains how a sale of your primary residence is taxed. The section on Risk has additional resources on the taxation of municipal bonds. This video is a great explanation of how Social Security benefits are taxed.
The government doesn't make it terribly easy to receive appropriate tax deductions for charitable donations. Those taking the standard deduction in 2024 get zero points with Uncle Sam for charitable donations. A single filer who donated $5,000 might still take the standard deduction because their itemized deductions were less than $14,600. This generous donor would receive the same deduction as a similar person who donated nothing.
How can we get the IRS to recognize our donations? The simplest way is to be someone who itemizes their deductions. An example of how itemized deductions can exceed the standard deduction is given in the second footnote. Because that married couple has itemized deductions that exceed the standard deduction before they make donations, they get deductions for every dollar donated.
For those who generally take the standard deduction, it helps to cluster your donations so that you can occasionally itemize deductions in one tax year. You could donate directly to charities or, if the amount is large enough, to a donor-advised fund (DAF). You can invest money earmarked for charity in traditional retirement accounts, but you can't use that money for tax-deductible donations until age 70½.
Most large charities accept securities as well as cash. If you own shares that have appreciated, you can avoid paying any tax on the gains and take a deduction by donating the shares to a charity or your DAF. If your charity of choice doesn't accept securities, you can donate them to a DAF, immediately sell, and grant the cash to the charity.
It makes sense to invest money in a DAF only if your entire donation, or a vast majority, is tax-deductible. Otherwise the 0.6% annual fees charged by Fidelity, Schwab, and Vanguard would consume more money than you can save through tax-exempt investing. A little math shows that even if your entire donation is deductible, the fees are so high that you're still likely better off continuing to invest that money in a tax-efficient stock ETF. Before eventually donating the shares, you would pay tax only on dividends, which would largely be taxed as long-term capital gains. Sadly, the fees make a DAF counterproductive for nearly all potential users who aren't (a) donating huge sums or (b) donating part of a windfall so that they can receive a deduction in that year, avoiding the end-of-year deadline and providing time to consider where to donate the money. However, as mentioned above, you can still use it as a transitional place to liquidate shares before granting cash to charities.
More information on charity and tax-advantaged accounts was given in a previous section.
Despite some great explanations online, there is pervasive confusion about taxes on monetary gifts. The IRS does not care about people gifting one another normal amounts of money, and very few people ever need to pay gift tax. In 2024, you can gift any number of people up to $18K each without tax reporting obligations. Once you exceed the $18K exemption for any gift receiver in a given year, usually you still have no tax liability. But you do have a reporting obligation. When the gift-giver files their taxes, they should report the excess over $18K that they've gifted to each person in that tax year. So if I gifted one person $10K and another person $25K in 2024, I would report the $7K taxable gift on Form 709, but I would probably not owe any tax. The excess over the annual exemption counts toward your lifetime gift tax exemption. The lifetime exemption is $13.61 million in 2024. Like the annual exemption of $18K, it's indexed to inflation and can change each year.
If you were to cumulatively gift more than $13.61 million beyond the $18K per-person exemption you're given each year, only then would you exhaust your lifetime exemption and pay gift tax. Reimbursements don't count as gifts, so sending someone money doesn't always count toward the annual exemption. Directly paying someone's medical bills or a student's tuition is also not counted as a gift for tax purposes. Property with monetary value, like a car or house, does count as a gift. Gifts given to a spouse (who is a US citizen) or to a dependent are not counted. If you're married, the limit is unchanged at $18K per person. You and your spouse could each give $18K to the same person in the same year without reporting obligations. The joint lifetime exemption is naturally doubled to more than $27 million. A vast majority of people will never be wealthy enough to potentially owe federal gift tax. The only states with gift taxes are Connecticut and Minnesota. There are a number of states with inheritance or estate taxes.
When I said the IRS does not care about gifting normal amounts, I meant it: even those who admit to failing to report gifts are generally not fined at all because no tax avoidance occurred. There is good reason to believe that enormous amounts of noncompliant gifting flow between US citizens every year, which the IRS does not address because it would require expensive and intrusive gathering of information in exchange for very little tax revenue.
Here are links to the rest of the sections:
- Tax-advantaged accounts
- Roth or traditional?
- Tax-efficient investing
- Wash sale rules
- Tax loss harvesting
- Estimated tax payments
- Summary
We introduced the basics of tax-advantaged accounts in a previous section. We'll cover some additional details here, starting with IRAs. Ensure that you've read the material above before starting this section: you need to know the terms adjusted gross income (AGI) and modified adjusted gross income (MAGI).
As mentioned previously, traditional IRA contributions are tax-deductible. However, if you're covered by a retirement plan at work — usually a 401(k) or 403(b) — and your income is high enough, this is not true. Everyone can contribute to a traditional IRA, but if your MAGI is at least $87K for single filers or at least $143K for joint filers, it will not reduce your taxable income. Single filers making $77K-$87K and joint filers making $123K-$143K can take only a partial deduction, based on a linear sliding scale. For example, a 40-year-old single filer with a 401(k) option at work is eligible to contribute up to $7,000 to their traditional IRA, but if their MAGI were $82K (halfway between $77K and $87K), they could deduct at most half that amount ($3,500) from their taxable income by contributing at least $3,500. Any contributions beyond $3,500 would not reduce taxes in the 2024 tax year. As mentioned previously, those who are at least 50 start with a higher maximum of $8,000.
These limitations mean that if your MAGI exceeds $77K (for single filers) or $123K (for joint filers), you’re better off ignoring your traditional IRA and investing through your employer-sponsored retirement plan (or your HSA!). If your employer doesn’t offer a retirement plan, then these income caps don’t apply to you, unless you’re married and your spouse is covered by a work plan. If only one spouse is covered by a work retirement plan, then deductions for traditional IRA contributions phase out between $230K and $240K.
If you make non-deductible contributions to your traditional IRA, you don't have to pay tax on the same money when withdrawing. For instance, if you withdraw from a traditional IRA with a value of $100K to which you've made $10K in nondeductible contributions, the amount added to your taxable income is only 90% of the withdrawal amount. You need to keep records of the total amount of your non-deductible contributions, and file Form 8606 for each year you make non-deductible contributions. For most people, it's easiest to completely avoid non-deductible traditional IRA contributions.
A non-deductible traditional IRA contribution is worse than a Roth IRA contribution in two ways. First, you can withdraw Roth IRA contributions at any time, tax- and penalty-free. But when you withdraw from a traditional IRA, you can't isolate the non-deductible contributions. You have to prorate your withdrawal between nondeductible contributions and the rest of the account, as described above. Only a fraction of the withdrawal is penalty- and tax-free; the remainder is subject to income tax (and the 10% penalty if you withdraw before age 59½). Having multiple IRAs doesn't allow you to sidestep this bothersome rule. Separate traditional IRAs at different brokerage firms are one big traditional IRA in the eyes of the IRS. Second, in a traditional IRA, all investment earnings are still subject to tax upon withdrawal. Massachusetts taxpayers enjoy even more complex rules for state taxes regarding this topic.
Not everyone can contribute directly to a Roth IRA: if your MAGI is at least $161K for single filers or $240K for joint filers in 2024, you cannot contribute to a Roth IRA. Reductions in the maximum contribution proceed on a linear sliding scale from $146K-$161K for single filers and $230K-$240K for joint filers. This income cap is nearly toothless, however, because anyone can still contribute the maximum to a Roth IRA through a backdoor. You first contribute to a traditional IRA and immediately convert it to a Roth IRA. When tax day arrives, you owe income tax on the contributions, as any Roth IRA contributor would. However, you can't withdraw converted funds penalty-free for five years, unlike direct contributions.
These income restrictions imply that for people with employer-sponsored retirement plans and high enough MAGI — single filers > $87K and joint filers > $143K — a Roth IRA or backdoor Roth IRA contribution is always superior to a traditional IRA contribution. However, this doesn't mean they should use a Roth IRA, because many such people would benefit more from additional contributions to their traditional 401(k) or HSA, thereby reducing taxes in the current year.
Even if gross income exceeds these thresholds, MAGI might not. If we're a 40-year-old single filer with a gross income of $170K, at first glance you might think we can't contribute directly to a Roth IRA. But if we max out our traditional 401(k) with $23,000 and our HSA with $4,150, we've reduced our MAGI by $27,150 and it now falls below $146K! No need for a backdoor.
Traditional 401(k) accounts have no income restrictions on tax deductibility, and Roth 401(k) accounts have no income restrictions on contribution limits. The issues discussed above apply only to IRAs. HSAs have no income restrictions under any conditions. Other contribution limits were discussed previously.
As you might expect, 401(k) contributions can apply only to the current year: contributions for tax year 2024 cannot be made after Dec 31 2024, and they need to be made through payroll deduction. HSA contributions do not need to be made through payroll deduction but it would be foolish not to do so, because contributing the money yourself would cause you to owe FICA taxes on that income. The only exception is if your employer does not offer pre-tax deposits to an HSA, but your health plan is eligible and you've decided to contribute on your own.
In contrast to 401(k) contributions, IRA and HSA contributions can be delayed until tax day of the following year (roughly April 15). This allows you to assess the tax consequences of traditional IRA contribution or whether you're eligible for direct Roth IRA contribution. If there is any uncertainty about whether your MAGI could make you ineligible for Roth IRA contributions, either perform a backdoor contribution or wait until the year is over. If it's uncertain whether traditional IRA contributions will be tax-deductible, you can (a) wait until the year is over, (b) perform a Roth conversion later if needed, or (c) accept that the contribution is non-deductible (which I don't recommend). When you contribute to an IRA, your broker will ask you to characterize the contribution: you will mark it as (a) for the current year, (b) for the previous year, or (c) from a rollover, most commonly from a 401(k).
The delay for your HSA provides more time for you to make contributions for the previous tax year, with greater information about whether your maximum for that tax year should be reduced. However, even by April 15, you may not be certain whether you can use the last month rule.
The retirement savings contributions credit — commonly called the saver's credit — is a major incentive for people with low income to contribute to retirement accounts. Depending on your AGI, between 10% and 50% of your contribution can be provided as a tax credit, with a cap of $1,000 for single filers and $2,000 for joint filers. A single filer with an AGI of $22,000 in 2024 could contribute $1,000 to a Roth IRA and receive $500 at tax time. Contributions to a 401(k) could potentially be rewarded with employer matching as well. Unfortunately, students enrolled full-time during any part of five calendar months of the tax year are ineligible. So it doesn't help most people in their year of college graduation, when they might have unusually low income compared to later years.
Recall the distinction between refundable and nonrefundable tax credits, as introduced in the basics. The saver's credit is nonrefundable, which means that it can lower your federal income tax liability to zero, but cannot reduce it further. The single filer with an AGI of $22,000 — assuming the whole amount is earned income — would owe $740 in federal income tax. So the saver's credit would be 50% of their IRA contribution for any contribution up to $1,480, but the credit could not exceed $740 (and regardless of circumstances, the credit cannot exceed $1,000). Even though they paid $1,683 in FICA taxes, income tax credits have no effect on this liability.
Beginning in 2027, the saver's credit will become a saver's match, in which the government will provide a 50% matching contribution for up to $2,000 of contributions. The matching contribution won't count toward the annual contribution limit.
No one should save all their retirement funds in either a traditional or Roth account — at least, no one who has been planning for retirement throughout their career and has always had both account types available to them. (The Roth IRA was established in 1997, and the maximum contribution in 1998 was $2,000.) We can illustrate this by considering two extreme investors who use only one type of account, and we'll name the characters Bob and William after the legislative sponsors of the Roth IRA.
First imagine Bob, who invested purely in Roth accounts. Bob cultivated a huge nest egg of tax-exempt money, and now every year when he withdraws during retirement, his income taxes are zero. This may feel like a great accomplishment, but it was a miscalculation that made him poorer. Let's back up to his last year before retirement, when he's in the 32% federal marginal tax bracket and the 8% state marginal tax bracket (the state brackets will be made up). He has all his money in Roth accounts and is considering where to contribute. If Bob chose to contribute to Roth accounts this year, he would pay 40% income tax on the contributions, then he would withdraw it in his first year of retirement and pay zero tax. (Red buzzer sound effect — wrong!) Instead, he could have paid zero income tax on the last year's contributions by contributing to traditional accounts, then zero or very little tax when withdrawing because his taxable income was so low! Bob did not have enough in traditional accounts: he surrendered wealth by frontloading taxes.
Alternatively, imagine William, who invested only in traditional accounts. He's happy that he made a ton of tax-deductible contributions, which greatly reduced taxes during his working years. In his first year of retirement, he withdrew enough to fall into the 24% federal bracket and 6% state bracket, so he pays a 30% marginal rate. To see where the mistake was made in this case, we need to back up to the beginning of his career. Sometime in his 20s, William started earning significant income and wisely contributing to retirement accounts. He contributed to traditional accounts despite being in the 12% federal and 2% state marginal tax brackets. (Red buzzer again.) We can imagine two journeys the money earned in his 20s could have taken.
Let's say that for five years William set aside $5K per year before income taxes, for a total of $25K. The $25K could have been contributed after taxes to a Roth account, so the contribution would have been $25K × .86 = $21.5K. Or the $25K could have been contributed in full to a traditional account. Let's say that in the next 40 years, these contributions are invested in stocks and multiply by 18 in nominal terms (i.e., not adjusted for inflation). So the Roth amount of $21.5K would grow to $387K and the traditional amount of $25K would grow to $450K. When the money is finally withdrawn from a Roth IRA over a number of years, there is no tax owed, so it is still $387K after tax. When the money is withdrawn from a traditional IRA each year and subject to 30% tax, the after-tax value of the withdrawal is smaller even though the pre-tax amount was larger: $450K × .7 = $315K. By contributing some money to Roth accounts, William would have been able to reduce his marginal (and effective) tax rates in retirement. He surrendered wealth by backloading taxes and paying too much tax in retirement.
So the question is not whether Roth or traditional accounts are better, but when it makes sense to contribute to each type of account. Pay taxes now or later? The goal is to distribute payment of income tax from your earning years to your non-earning years, but not by so much that you pay higher tax rates during non-earning years. Executed properly, this decreases your lifetime tax paid and increases your wealth significantly.
An important external factor is whether tax brackets change over time (aside from inflation adjustments). If you expect income tax to be higher in the future, this should increase the weight you give to Roth accounts; if you expect income tax to be lower in the future, this should advantage traditional accounts. I don't recommend attempting to make these predictions. (Those who think high federal debt implies that income tax rates must rise in the future should consider that there are other forms of tax: a federal consumption tax, for instance, could be used to raise tax revenue.) Although most Americans plan to live in the US permanently and are forced to accept federal taxes, you can choose to move between states. If you intend to retire in a state with lower income tax than the state(s) you work in, this would advantage traditional accounts; if your retirement state has higher income tax, this would advantage Roth accounts.
Although I don't recommend trying to predict future federal tax rates, it's unwise to rigidly assume that tax rates will be constant. Changes to tax rates should be recognized as a risk. The risk is especially large for high earners, since the top marginal tax rates could be greatly raised. The risk is also elevated for young people, since tax rates 30-40 years in the future are especially unpredictable. I think it's rational, especially for high earners and young people, to contribute more to Roth accounts than you would under the assumption that tax rates will not change.
However, there are two other risks that favor traditional accounts! These are (a) the risk that investment returns will be lower than expected and (b) the risk that you'll save less than you expect in retirement accounts (either due to lower income or higher spending). Traditional account contributions are a hedge against both possibilities, because if you have less money in your retirement accounts than you expected, you'll pay lower tax than you expected. And if you have more money than you expected — due to more saving or better investment returns — you'll be able to afford paying higher average tax rates. Scott Cederburg discussed these risks in a Rational Reminder interview and this paper.
When I wrote above that no one should use only Roth or only traditional accounts, one of the caveats was that this is true only for those who planned for retirement throughout their career. It may not apply to someone starting to invest for retirement at age 50. Even combined with Social Security benefits, it's likely that they'll struggle to build a retirement portfolio that can support the spending they're accustomed to in their working years. They'll be in a lower tax bracket during retirement than they will during the entire period in which they're contributing to retirement accounts. So contributing only to traditional accounts may be appropriate for this person. There is virtually no one for whom contributing only to Roth accounts is sensible.
Marginal tax rates are not static. Let's say someone is a single filer in 2024 with $50,150 of ordinary taxable income. The threshold for the federal tax rate of 22% is $47,150, so $3,000 of their income is taxed at 22%. They could contribute $3,000 to a traditional IRA, which would reduce their taxable income and drop their marginal tax rate to 12%. Now none of their income is taxed at 22%. If their marginal federal tax rate in retirement might be more than 12%, it could make sense to contribute the remaining $4,000 to a Roth IRA.
FICA taxes are not relevant to the question of Roth vs. traditional accounts, because regardless of retirement contributions you immediately pay FICA taxes on that income. However, it is relevant when you consider contributing to an HSA, because HSA contributions through payroll deduction are not subject to FICA taxes.
In your early years of retirement, under most circumstances it makes sense to draw down your taxable assets first. During this period, your taxable income is likely to be low, so it presents a perfect opportunity for Roth conversion. This means that you'll transfer money from your traditional IRA to your Roth IRA and add that amount to your taxable income. Those funds will be able to grow tax-free in your Roth IRA and will be withdrawn or inherited tax-free. During your working years, Roth conversions can be considered if you experience a year with unusually low income, perhaps due to taking a break from work. One reason to contribute to traditional accounts is to give yourself the opportunity to carry out Roth conversions and pay low tax rates during years when the chance to use those low tax brackets would have otherwise been squandered.
If you have a long-term partner, all these considerations need to be placed in the context of your combined finances, regardless of whether you are legally married and file taxes jointly.
Another layer of complexity is added when you consider inheritance. Although most people don't think much about estate planning until at least middle age, unexpected death can happen at any time without warning. Everyone should have beneficiaries named on all their accounts and understand the tax consequences. Beneficiaries named on an account supersede your will. New rules for inheritance of retirement accounts took effect for those who die in 2020 or later. IRS guidance on the rules was published in February 2022, calling into doubt certain assumptions people had made about the new rules. Clarity was finally established in October 2022. When your beneficiary inherits an IRA, in most cases they will be required to empty the account by the end of the tenth year after the death of the original account owner. Death anytime in 2024 would require depletion by the end of 2034, because the ten-year period would be 2025-2034. With a Roth IRA, the beneficiary can take distributions on any schedule as long as the account is empty within ten years. With a traditional IRA, it depends: if the deceased was not already taking RMDs, the distribution schedule is just as flexible as that of a Roth IRA. But if the deceased was already taking RMDs, the beneficiary must start taking RMDs in the year after death and distribute the remainder in the tenth year. Withdrawals from an inherited traditional IRA are subject to income tax. But if someone inherits a Roth account, the taxes have already been paid. Depending on your tax rates during retirement and the beneficiary's expected tax rates in the years following your death, it may make sense for you to perform a Roth conversion even if it doesn't maximize your wealth, because it will maximize your beneficiary's wealth.
If your tax rates in old age are lower than those your beneficiary expects in the ten years after you die, Roth conversions should be considered. This can also influence which accounts you assign to different beneficiaries. If you have two children with different incomes and you'd like them to inherit equal amounts, you could leave more than half of the traditional IRA to the child who earns less, and more than half of the Roth IRA to the child who earns more. This would increase the after-tax value of the inheritance. If the beneficiary is an "eligible designated beneficiary" such as a spouse or a minor child, the distribution schedule permits more flexibility. Details are explained in IRS Publication 590.
The most important aspect of tax-efficient investing is to contribute as much as possible to tax-advantaged accounts as early in life as possible. The best approach to tax-efficient placement of different funds is debatable, but maximizing the space in your tax-advantaged accounts is undoubtedly good.
A central component of tax-efficient investing is deferring realized gains. We can illustrate this with a simplified example. Imagine a risk-free investment in a taxable account that increases in value by 10% every year. If we invest $1,000 and hold for 20 years without selling, the value would be $6,727. Let's say we sell and pay 15% tax on the entire gain, so the final after-tax value is $5,868. Now imagine an alternate scenario in which we think it's a good idea to evenly spread out the taxes. We decide to sell at the end of each year, so we're taxed on our 10% gain and invest the remainder. Since our 10% gain each year is taxed at 15%, our after-tax annual return is 8.5%. The final value after 20 years would be $5,112.
By deferring tax, we were able to increase the average annual after-tax return from 8.5% to about 9.25%. Why such a large difference? By declining to realize the gain, we held on to the money we would have paid in tax each year and continued to invest it. The $15 that would have been paid in tax the first year was invested for another 19 years before finally handing it over to the IRS. Note how small that $15 seems, but how the practice of deferring tax every year resulted in a difference of over $750 on an initial $1,000 investment.
The effect expands as the period of deferral increases. The average annual after-tax return for this approach is 8.72% after 5 years, 8.94% after 10 years, 9.25% after 20 years — as mentioned above — 9.44% after 30 years, and 9.57% after 40 years. This compares to 8.5% returns if you realize gains every year.
Distributions include dividends as well as capital gains (CG) distributions from funds. For the same reason that realizing gains prematurely is inefficient, distributions are inefficient compared to capital gains. If the 10% annual gain in our imaginary investment were instead a 10% annual dividend, it would be as bad as the scenario in which we sold every year. Distributions are an involuntary taxable event that you cannot defer in a taxable account.
Tax-advantaged accounts are so great partly because they allow tax on every distribution and realized capital gain to be deferred, potentially for decades.
Funds are more tax-efficient if:
(A) They have lower yield. Lower dividends and CG distributions allow the shareholder to defer more of their gains.
(B) More of their distributions are taxed at long-term CG rates. This includes qualified dividends and long-term CG distributions.
The total return of a perfectly tax-efficient fund would be strictly capital gains: it would have no distributions. The total return of a perfectly inefficient fund would be wholly composed of distributions that are taxed as ordinary income and paid at least annually.
Total stock market ETFs like VTI are quite tax-efficient. Most of their total return arises from capital gains, dividends are mostly qualified, and there are no CG distributions. Even total stock market mutual funds are nearly as efficient because they include all stocks and don't have to add or remove companies when the index is updated. (Adding or removing companies can trigger capital gains that have to be passed on to mutual fund shareholders.) Bond funds are less efficient because a much larger proportion of their total return arises from dividend payments, and their dividends are always taxed as ordinary income. Bond funds — both ETFs and mutual funds — sometimes distribute capital gains, which may be short-term, long-term, or a combination. Funds that exclusively hold real estate investment trusts (REITs) are also relatively tax-inefficient because they have high yields and their dividends are mostly non-qualified. REITs are included in total stock market funds. Target retirement mutual funds can have large CG distributions, so they shouldn't be held in a taxable account.
To evaluate the tax-efficiency of a specific fund, you can check its past distributions, which tend to be good indicators of future distributions. If a fund is new, you can check similar funds with longer histories.
Asset location refers to the strategic placement of different assets in taxable, tax-deferred, and tax-exempt accounts. This White Coat Investor post rebuts the major misconceptions about proper asset location. He describes how tax efficiency and total return combine to produce a total tax cost, and how to think about one's portfolio in traditional vs. Roth accounts. This Bogleheads post covers some additional, minor details.
Once you've advanced beyond the common misconceptions, we can consider the following. We would be able to design perfectly tax-efficient fund location if we knew:
- Future tax rates, our future earned income, and the state to which we'll pay taxes in each year
- Future returns for all funds we'll hold
- The characteristics of future returns (capital gains, distributions taxed as short- or long-term capital gains)
Of course, with this level of predictive ability, we could quickly become the richest person alive. So what can we do with realistic knowledge of the future? Funds with higher tax cost are more suitable for tax-advantaged accounts. There are two components of tax cost: total return and tax efficiency. So, all else equal, funds with higher expected return and lower tax-efficiency should be overweighted in tax-advantaged accounts. But because ideal fund locations vary so much depending on the three factors above, which we can't know in advance, it's not possible to carry out anything close to perfect asset location. Will a stock fund with an expected return of 9% or a bond fund with an expected return of 5% have a higher tax cost? The bond fund generates involuntary taxable events every month, and its dividends are taxed as ordinary income. The stock fund has dividends taxed mostly as long-term capital gains, but its gains are expected to be larger than those of the bond fund, and those larger gains will eventually be taxed when the shares are sold.
If we form a strategy that depends on particular expectations, it has a strong chance of underperforming the default strategy of holding the same funds in all accounts. On top of that, a complex approach to fund placement can add mental overhead and make it harder to rebalance.
So we should take only the low-hanging fruit, if we take any. If you choose to buy REIT funds, they should be held in tax-advantaged accounts because they have both high expected return and poor tax efficiency. Bonds with very high yields should be overweighted in tax-advantaged accounts. Note that bonds with high yields aren't necessarily junk bonds: even three-month US Treasury bonds had current yields as high as 16% in the early 1980s. But in the current interest rate environment, holding bonds equally across accounts is a good approach. Bond funds with very low yields, like money market funds in most environments, should be placed in a taxable account. The no-brainer of asset location is to buy tax-free municipal bonds issued by your own state in a taxable account. But municipal bonds are suitable only for those who pay high tax rates, and while muni bond income can be tax-free, certain capital gains are taxable.
Ben Felix has a video on this from the perspective of Canadian tax law, but his conclusion is the same as mine for largely the same reasons. Efficient location is so sensitive to the three variables above that any strategy intended to slightly reduce taxes could also slightly increase taxes, depending on future conditions.
A pervasive recommendation in this guide is Vanguard's total world stock ETF, VT. Its simplicity is appealing, but policy around the foreign tax credit (or deduction) leads to a minor caveat. When you invest in funds with international exposure like VT, some tax is withheld from dividends paid by the fund. The foreign tax credit means that you can often reduce your tax owed to the IRS if tax was withheld by a foreign country. However, the US tax code states that in order for a fund to be eligible for the foreign tax credit, foreign assets must constitute more than 50% of the fund's value at the end of the tax year. Since VT's portfolio is more than 50% US stocks, the foreign tax credit does not apply. The withheld taxes are retained by the foreign government, and you still owe that amount to the IRS.
So for someone willing to add a little complexity to their portfolio for a slightly better tax outcome, VT can be split into a total US component (VTI, ITOT, SCHB) and a total international component (VXUS, IXUS). Taxes withheld from dividends paid by VXUS or IXUS are eligible for the foreign tax credit. A fund-of-funds does not have the same issue as a simple global fund. Funds like BNDW, AVGE, and AOR are compatible with the foreign tax credit because they hold 100% ex-US funds alongside 100% US funds.
Other countries don't recognize US tax-advantaged accounts, so none of this applies to foreign tax on dividends you receive in tax-advantaged accounts. You cannot be reimbursed with a US tax credit even though the foreign tax is withheld, so VTI/VXUS has no tax-related benefit over VT in tax-advantaged accounts. You can see in the complex portfolio of the funds section how that portfolio invests in VT in a Roth IRA, but invests separately in SCHB and VXUS in a taxable account.
Absent wash sale rules, someone could artificially declare a loss for tax purposes by selling a poorly performing stock near the year’s end and buying it again immediately. Under US tax law, the realized loss would count as a "wash sale" and would be deferred for tax purposes. Of course, this position — whether the investor decides to close it in the given year or in a later year — will affect their taxes at some point, although waiting to close could result in an eventual profit. But wash sale rules prevent investors from exercising total control over the year in which capital losses qualify as tax deductions.
What are the details? If you close a position that resulted in a loss, the IRS will view it as a wash sale if it is replaced within the 61-day window starting 30 days before and ending 30 days after the sale. That is, the losses will be deferred for tax purposes until the new position is also closed. Frequent trading on the same security can lead to indefinite deferral of any losses; the loss can be transferred to the cost basis of the next trade an unlimited number of times. The loss or losses will be tax-deductible once a non-wash sale occurs. Unlike losses, gains are always taxed in the year they were realized.
Imagine you buy 50 shares of a stock at $40 on April 15 of Year 1 and sell them at $60 on May 15, for a gain of $1,000. You buy 50 shares of the same stock at $55 on July 1 and sell at $25 on October 1, for a loss of $1,500. Finally you buy 50 shares at $20 on October 15 and sell at $22 on January 15 of Year 2, for a $100 gain. In March you pay your Year 1 taxes. Without the wash sale rule, the first two sales would apply to your taxes in Year 1, and you would deduct the $500 net loss from your income. But because you repurchased a security on October 15 within 30 days of selling the same security at a loss, the IRS will count the October 1 sale as a wash sale. For tax purposes, the loss in this case will be deferred to Year 2. You will pay taxes on your $1,000 capital gain even though your stock trading in Year 1 resulted in a net loss of $500.
The example above has important implications which become more evident when magnified. If someone has gross gains and losses which are far larger than their net gain, and they inadvertently defer some of their losses to the following year, the results can be troublesome. One amateur day trader made a net profit of $45K on top of his salary of $60K in 2020 after thousands of trades, but because he unwittingly deferred much of his seven-figure gross losses to the 2021 tax year, his capital gains for tax purposes were enormous. The tax bill was over $800K.
How exactly are wash sales counted for tax purposes? We can illustrate it by returning to our example above. The cost basis of your first purchase on Apr 15 was $40 × 50 = $2,000 and the value upon sale on May 15 was $3,000, yielding a $1,000 profit. None of this was affected by the future wash sale. When you bought 50 more shares on July 1, the cost basis was $2,750 and the value upon the Oct 1 sale was $1,250. Because the Oct 1 sale was rendered a wash sale by the repurchase on Oct 15, the loss of $1,500 was transferred to the cost basis of the new purchase. So the Oct 15 adjusted cost basis was $20 × 50 = $1,000 plus the loss’s magnitude, yielding $2,500. Had you sold before the end of Year 1 and not repurchased within 30 days, the wash sale would not have affected your taxes. But because you held the stock until Jan 15, the loss was deferred to Year 2. The value upon selling at $22 was $1,100. This yielded a $100 profit, but for tax purposes it served as a loss: $1,100 - $2,500 = -$1,400. As long as another repurchase does not occur within 30 days, the IRS will recognize the $1,400 loss in Year 2.
-A wash sale can be triggered inadvertently by dividend reinvestment. If you sell some but not all shares of a dividend-paying security, and a dividend is reinvested within 30 days before or after the sale, the sale will be designated as a wash sale.
-You can’t avoid a wash sale designation by selling stock at a loss in a taxable account, then repurchasing it in a tax-advantaged account. The same applies to a repurchase by your spouse. If you repurchase in a tax-advantaged account, the loss is disallowed and cannot offset any gains. This is the worst punishment for ignorance of wash sale rules, because you permanently lose the ability to claim those losses. It's easy to do accidentally if you aren't keeping the rules in mind. If you sell investments at a loss in your taxable account to contribute the cash to your IRA, then buy the same funds in your IRA less than 30 days later, you've made this error.
-When the loss from a wash sale is transferred to the cost basis of the repurchased security, the first holding period is added to the holding period of the newly purchased security. This potentially qualifies the combination as a long-term capital gain or loss when it would not have otherwise.
-Wash sale rules can’t be sidestepped by selling a stock and then purchasing an option on the same stock, for example. Repurchase of a “substantially identical” security, like a derivative, invokes the same wash sale rules.
-This is another regulation which can be bypassed if the IRS recognizes trader tax status.
You don't need to meticulously avoid wash sales. They're not inherently bad and they don't complicate your tax return much. But ideally, you should be conscious of creating a wash sale every time you do so.
Tax loss harvesting is the conscious use of realized losses to offset realized gains for tax purposes. We'll walk through an example, and also discuss a major caveat that many people don't consider.
This video is a brief intro to tax loss harvesting and this podcast is a great discussion.
Let's imagine that most of your stock portfolio is allocated to VTI and VXUS, Vanguard's total US and total international stock ETFs. Earlier this year, you sold shares of VXUS and moved the cash into bond funds to rebalance your portfolio. It's unrealistic that rebalancing the stock/bond ratio and rebalancing within the stock portfolio required selling only VXUS, but we're trying to keep this example simple. You had held these shares for a long time, so the gains you realized were long-term capital gains and they amounted to $4,000. (Note that this doesn't mean you sold $4,000 of VXUS. It means the shares you sold had appreciated by $4,000.)
You're trying to minimize your taxes at the end of the year, and ideally you'd like to do so in a way that doesn't substantively change your portfolio. Let's say you buy VTI (and other funds) whenever you get a paycheck, so you have shares of VTI you've purchased within the last year. VTI has been doing poorly and your recently purchased shares have lost value. You're able to sell shares using the LIFO disposal method (last in, first out) and realize $3,000 in short-term losses. We'll pretend you didn't receive any dividends, and that your only realized gains and losses are $4,000 in long-term gains from VXUS and $3,000 in short-term losses from VTI.
However, we don't want this to change our portfolio. We also don't want to trigger a wash sale by immediately repurchasing VTI. So as soon as we sell VTI at a loss, we buy an equivalent amount of SCHB, another total US stock ETF. We know they will have highly similar returns because, according to this tool, the weighted allocations of VTI and SCHB have an overlap of 97%. Yet the IRS does not consider them “substantially identical” securities, because they track different indices. Unfortunately, the IRS has never provided clear guidance on precisely what criteria would make two funds substantially identical or not. It may even be perfectly fine to switch from one S&P 500 ETF to another, but I would avoid switching between funds that track the same index. Any similarity beyond that is not a concern.
This is a clean example of tax loss harvesting, in which we offset $4,000 in realized gains with $3,000 in realized losses and pay taxes on only $1,000 of long-term gains. We would naturally want to prioritize the reduction of short-term gains, if we had any. But while this harvesting of losses may seem obviously good, there's a potential drawback. Let's imagine that two years in the future, we've held the shares of SCHB and need to sell them. They've appreciated by $10,000, and there are no losses we can realize to counterbalance these gains. Consider the counterfactual: if we had kept the shares of VTI we sold, and sold those now, the tax bill would be smaller this year. Instead of paying taxes on $10,000 of gains, we would have had to initially recover from $3,000 of unrealized losses, and we would be paying taxes on $7,000 of gains.
This is crucial to understand about tax loss harvesting: when you harvest a loss, the new investment that replaces it has a lower cost basis (e.g., the cost basis of the SCHB purchase is lower than that of the VTI purchase). This enlarges the realized gain in the future. So tax loss harvesting does not make taxable gains disappear; it merely defers realization of gains. If your income were significantly higher in the year when you sold SCHB, your taxes may have increased more in that year than you saved in taxes two years prior by selling VTI. This concern is more relevant for short-term gains than long-term gains, because changes in your income are much more likely to affect your marginal tax bracket for ordinary income than for long-term capital gains.
So be thoughtful if you decide to harvest losses. Is your income likely to increase in the near future? If so, reducing your taxes this year by realizing losses may lead to an even bigger increase in your future taxes. If you're taking a break from work and you anticipate an income drop next year, then minimizing taxes this year could make sense. In addition, keep in mind that while total market index funds are easy to replace with another security, more specialized products are not. There are many substitutes for VTI that could be used to avoid wash sales, but not for AVES. Active funds like those from Avantis and DFA can be switched to other active funds, even those with similar strategies. So AVES could be replaced with DFEV for tax loss harvesting purposes.
When tax loss harvesting, make sure you don't purchase shares of the same fund in a tax-advantaged account within 30 days of selling at a loss in your taxable account. You'll lose the ability to harvest those losses; they just won't count. I already emphasized this in the wash sale section, but it is such an easy error to make that I think it's worth repeating.
Hopefully you've noticed that when you receive a paycheck, some of your money is missing. Since the second world war, the federal government has not waited until tax day to take your money — they want it now. Your capital gains are not entirely exempt from this policy. If you wait until you file your taxes to pay tax on your realized capital gains, under certain circumstances the IRS will charge you interest and even penalties for paying that tax late. They may expect you to make estimated payments throughout the year.
Under what circumstances do you need to pay estimated tax? Thankfully, taxpayers can often safely ignore this provision. You do not need to make estimated payments if (a) you expect your federal withholding to be at least 90% of the total federal tax you owe; (b) you expect your federal withholding to be at least 100% of the tax you paid the prior year; or (c) the underpayment you anticipate will be less than $1,000. If any one of these statements is true, you do not need to make estimated payments. The figure in condition (b) is increased to 110% if your AGI in the prior year was over $150K.
If you find that you do need to pay estimated tax, how do you do it? The simplest method is to increase federal withholding through your employer. You'll effortlessly pay the correct amount of taxes, as long as you accurately estimate your total tax liability. The main alternative is a series of four, equal payments throughout the year. These are due by the 15th days of April, June, September, and January (in the following year). If you noticed that these dates are not spaced equally, that’s correct. When these dates don't fall on a business day, then the due date is postponed to the first business day afterward. There are multiple ways to pay the IRS, the easiest of which is an online transfer directly from your checking account.
There's more information on estimated payments in IRS publication 505. It's not as bad as it sounds. They even made a flowchart here.
The practice of "estimated tax" may strike some people as guesswork. How can you be sure you're paying enough before the end of the year? Remember that condition (b) above sets a hard limit on the amount you're expected to pay before tax day. You're all set as long as you pay the IRS as much as you paid in federal taxes the prior year — or, if your income is high, 110% of what you paid the prior year. This is known as the "safe harbor" rule. If your tax liability has decreased compared to the prior year, following only this guideline could lead to significant overpayment, so keep the other conditions in mind.
States often require estimated tax payments under certain conditions; research the requirements of your state(s).
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Understand the basics: marginal vs. effective tax rate; return vs. refund; filing status; dependent; tax year; credit vs. deduction; refundable vs. non-refundable credit.
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Understand the essentials: gross income, AGI, and MAGI; standard deduction vs. itemized deductions; long-term vs. short-term gains and losses; FICA taxes; FIFO disposal method; qualified dividend; gift tax exemption.
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Understand the income restrictions (based on MAGI) that apply to traditional and Roth IRAs, and the appropriate timing for contributions to tax-advantaged accounts. The saver's credit is a major tax credit for low-income people who contribute to retirement accounts.
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The properly balanced use of Roth and traditional retirement accounts will attempt to distribute payment of income tax from your earning years to your non-earning years, but not by so much that you pay higher tax rates during non-earning years. There are a number of factors to consider each year when deciding whether to contribute 100% to Roth accounts, 100% to traditional accounts, or some combination.
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The most important aspect of tax-efficient investing is to contribute as much as possible to tax-advantaged accounts as early in life as possible. In taxable accounts — all else equal — you should hold investments for as long as possible to defer any tax; you should prefer to realize long-term gains over short-term gains; you should prefer funds with qualified dividends to those with non-qualified dividends; you should prefer funds with no capital gains distributions; and you should prefer funds with lower yield because distributions are tax-inefficient. The benefits of strategic asset location can be exaggerated, but there are some low-hanging fruit like locating REIT funds in tax-advantaged accounts. There is a minor tax incentive to split global funds with more than 50% US allocation into US and international funds.
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A wash sale occurs if a position sold at a loss in a taxable account is replaced within the 61-day window starting 30 days before and ending 30 days after the sale. The loss is deferred for tax purposes, and the magnitude of the realized loss is added to the cost basis of the new position. You need to be especially careful of accidentally triggering wash sales by purchasing shares of the same fund in your IRA or HSA, because in that case the loss is permanently disallowed, not simply deferred.
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Tax loss harvesting is the conscious use of realized losses to offset realized gains for tax purposes. It can be beneficial but — in contrast to the illusion many people have about making taxable gains vanish — it merely defers realization of gains. Deferring gains is often great, but it's not always the right decision. Avoiding a wash sale is an essential part of proper tax loss harvesting.
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You may need to make estimated tax payments if your employer withholding will fail to meet your total tax liability (or if you're self-employed). There are various exceptions, most notably the "safe harbor" rule based on your tax liability in the prior year.
Click here for the next section — Vocabulary and further resources
All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
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Footnotes:
1 Student loan interest can reduce your taxable income in addition to the standard deduction because it can be used for an above the line deduction. It reduces your adjusted gross income, which is calculated before you take the standard deduction. The student loan interest deduction is limited to $2,500 per year, and your income must be low enough. Contributions to your HSA, 401(k), and IRA can also be above the line, with income caveats for the IRA but not HSA or 401(k). ↩
2 Let's say a married couple who owns an expensive home is considering whether to itemize deductions or take the standard deduction of $29,200. They paid a lot in state and local income and property tax, so they can deduct the maximum of $10,000 from their federal taxable income (see the SALT deduction). They recently bought their home and pay a great deal of mortgage interest. Let's say they paid $25,000 of deductible mortgage interest. And let's say they donated $2,000 to charity. They choose to itemize because they can deduct $37,000 instead of $29,200. If their marginal tax rate is 24%, deducting an additional $7,800 saves them $1,872 in federal income tax compared to the standard deduction.
Medical expenses above a high threshold determined by your AGI can also be used as an itemized deduction. The medical expenses that can count are broader than you might think. Deductible medical expenses don't even have to be for yourself; paying for the expenses of others can also be deductible. ↩
3 This is a lesser-known fact of federal US taxes: it is assumed that being married provides a tax advantage, but being married is actually detrimental for some high earners. Many thresholds for joint filers are far less than double the single filer threshold.
The additional Medicare tax kicks in at $200K for single filers vs. $250K for joint filers (only 25% greater); the net investment income tax (which also funds Medicare) has the same thresholds; the top marginal rate for income tax has a threshold only 20% greater for joint filers, and the top marginal rate for capital gains has a threshold only 12.5% greater; Social Security benefits have thresholds of $25K/$34K for single filers and $32K/$44K for joint filers (only 28%/23% greater); the ability to deduct traditional IRA contributions completely phases out at a threshold only about 64% greater for joint filers; eligibility for direct Roth IRA contributions completely phases out at a threshold about 49% greater for joint filers; and interest on US Treasury savings bonds is tax-deductible if used for education, but the deduction is phased out at a MAGI threshold which is about 57% greater for joint filers than single filers.
In addition, high earners are more likely to itemize their deductions. The state and local tax (SALT) deduction is $10K for single filers, as well as $10K for joint filers. This is the largest marriage penalty in percentage terms, cutting the per-person deduction in half.
Even with all these marriage penalties, it's possible for high-earning couples with imbalanced incomes to have a lower overall tax bill as a result of being married. Imbalanced incomes for joint filers are favored by federal income tax, as long as they don't reach the top marginal rate of 37%.
The poorly coordinated dynamics of government welfare programs can also create marriage penalties for low-income Americans. ↩
4 There is a funny region of $125 of taxable income in which the marginal rate for ordinary income is lower than the marginal rate for long-term capital gains. The 0% capital gains rate increases to 15% above $47,025 for single filers. Someone with a taxable income of $47,100 pays a marginal rate of 15% on capital gains but a marginal rate of only 12% on ordinary income! The threshold for the 22% rate is $47,150 for ordinary income. ↩
5 If you receive less than $10 of dividends through a given broker, they are not required to report it to the IRS and will generally not do so. However, you're technically still supposed to report those dividends. On your 1099-DIV, Box 1a reports the total dividends you received through that broker and Box 1b reports the subset of those that your broker has deemed qualified dividends. They may not always report your qualified dividends correctly. They may deem a dividend qualified even though it didn't satisfy the 60-day holding period. In this case, I did not report those dividends as qualified even though my broker did, so I reduced the figure in Box 1b.
Sometimes dividends from a foreign country will have tax withheld. You can claim a tax credit that reduces your tax owed to the IRS. If foreign taxes are withheld while you're investing in a tax-advantaged account, you can't be compensated with a tax credit. ↩