There’s really no way around it: Taxes aren’t exciting.
But they are an unavoidable part of investing. If you’re making money, you will be on the hook for taxes in some form or another. Here are the tax fundamentals we think every investor should know, whether you’re opening your first investment account or want to know why we’re constantly talking about taxes in your Ellevest goal forecasts.
Why You’ll Pay Taxes
Because you’ve made money, or — in IRS speak — realized gains, from your investments. To start, you have to pay taxes after selling an investment at a price that’s higher than what you paid for it. (“You” is somewhat figurative here because we actually do the selling and buying for you, but more on this in a bit.)
This is the capital gains tax. Typically, capital gains tax rates depend on your household income level and how long you have held the security.
Held onto that investment for a year or less? Then the IRS considers the money you made from selling it a short-term gain, and you’ll be taxed at your ordinary income tax rate. Depending on your tax bracket, this rate can be anywhere from 10% to 39.6%. If you held that investment for longer than a year, your profit from the sale is viewed as a long-term gain — and you’ll be taxed at a lower rate. That’s 15% for most people, though you might pay 0% or 20%; it really depends on your ordinary income tax rate.
At Ellevest, we sell the exchange traded funds (ETFs) in your investment portfolio when you want to withdraw money from your account, when we’re rebalancing your portfolio, and/or we believe you should be invested in a different ETF altogether.
The first reason is pretty self-explanatory...the money you’re withdrawing has to come from somewhere. With portfolio rebalancing, we buy and sell investments to bring your portfolio’s asset allocation — its mix of stock, bond, and alternative ETFs — back to your target asset allocation. Market movements can shift this, so we rebalance your portfolio when the asset allocation strays too far. Finally, sometimes we swap out your ETFs for new ones because our analysis shows that the costs, risk levels, and/or diversification offer more benefits for your portfolio.
Capital gains taxes aren’t the only taxes you stand to pay as an investor. You’re also responsible for paying taxes on any income you earn in your portfolio from dividends or interest. (Dividends and interest are payments you get for being a shareholder, and some of the stocks or bonds that make up the ETFs in your portfolios pay them...which is how you end up with income.)
Besides income from municipal bonds, which isn’t taxed, interest and ordinary dividends are always taxed at your income tax rate. Meanwhile, qualified dividends — which have to meet specific IRS criteria — are taxed at the long-term capital gain rate.
When You'll Pay Taxes
Generally speaking: If you make any money while investing — say, capital gains from a profitable sale in your portfolio or a dividend payment or interest earned from an investment — in a taxable investment account, you pay taxes on that money when you file that year’s income tax return. (We’ll provide you with the tax forms you need for that.)
However, individual retirement accounts (IRAs) handle taxes differently because IRAs are tax-advantaged accounts. A traditional IRA is a tax-deferred account, so your contributions may be tax-deductible — depending on your income level — and your investment earnings grow tax-free. Once you’re 59½-years-old, your withdrawals are taxed as income; take out money earlier, and you may be hit with an added tax penalty.
With a Roth IRA, your contributions aren’t tax-deductible, but the upside is that you don’t pay any taxes on withdrawals. Well, so long as you’re at least 59½ and have had your Roth IRA for a minimum of five years when you take out money. However, if your income level is too high, you won’t be eligible for a Roth IRA.
Taxes on the Brain
At Ellevest, we’re constantly using tax-smart techniques on your behalf. This starts with the low-cost, tax-efficient ETFs we use across all of our investment portfolios. It continues with us being really deliberate with the asset classes we put in taxable, non-retirement accounts because we want to use ones that minimize the odds of taxes eating into your potential returns. We also reinvest dividends and interest in a way that minimizes transactions, so you’re less likely to trigger a taxable event —which is IRS speak for “you’re going to owe taxes for this.” Lastly, while rebalancing your portfolio, we maximize losses and minimize your gains whenever possible to reduce your capital gains tax.
Taxes play a big role in the forecasts for each of your goals at Ellevest too. We account for the estimated impact of taxes — based on what your personal tax rate may look like over the years — while calculating your forecast to help you see how much after-tax money you may have for your goal when you’re done investing. That’s not something most digital advisors do.
Let’s repeat that: that’s not something most other digital advisors do. Instead, they’ll show you a higher, pre-tax forecast that looks nice on screen; but it doesn’t represent that most investors pay taxes on capital gains, dividends, and earned interest annually.
Those taxes add up. Which makes you wonder...how much of that pre-tax forecast are you likely to have for your goals after you pay those taxes? We’d rather give you a clearer, after-tax forecast (even though that means it’s lower than others’) so you have an idea as to how much money you’ll have to spend when your goal date arrives.
Also worth mentioning: Our focus on helping you reach your goals is a big reason why we don’t do automated tax loss harvesting. Automated tax loss harvesting is a strategy in which one sells investments that have declined in value and use those losses to offset any capital gains (and the taxes that come with them). Proponents say it lowers taxes and increases after-tax returns.
Sure, automated tax loss harvesting can lower your taxes...but only for the time being. This strategy almost always pushes your taxes back, so you’ll end up paying the IRS when you eventually withdraw your money — which is when you need as much money as you can get. Another fun fact about tax loss harvesting? It only eliminates taxes when you donate your investments to charity or pass them down to heirs, and you can get the same tax break by doing those things yourself. No tax loss harvesting necessary.
We’ll stick to minimizing your taxes the Ellevest way: with investment portfolios built with tax-smart techniques and forecasts that account for taxes — all so we can help you see and reach your goals.
The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.
The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.
Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.