The powerful potential of the tax swap

Most investors fixate on their returns. But there’s a second stat that can quietly work against them: their tax bracket. And unlike market returns, your tax bracket is something you can actually influence.

Investors accomplish this by way of tax arbitrage—a tax “swap” of sorts. The core insight is simple: your tax bracket isn’t fixed. It changes over your lifetime, and in response to the choices you make.

Sometimes the opportunity arises to swap a tax for a lower (and/or later) one, and these moves can make a meaningful difference in how much of your investing returns you actually keep in the long run.

First, a quick tour of how taxes work

The U.S. tax system is progressive, meaning income is taxed in layers. Each slice is taxed at a higher rate than the one below it, so while it’s common to hear about your tax bracket (as in, singular), your income often falls into multiple brackets (as in, plural). Tax swaps are all about maneuvering around your top tax bracket and its associated tax rate.

As your income grows over time, your last few dollars earned will sometimes break into a higher bracket. And vice versa, when you earn less in a given year—say in retirement or in between jobs—you may slide down a bracket or two. These movements present an opportunity.

Two common types of tax swaps

Tax deferral: Reducing taxable income today, and buying time for compound interest to do its thing

The first example is also the most straightforward: swap a tax today for one down the road.

For many people in their peak earning years, that future point is retirement. Let’s say you’re hypothetically in the 22% income tax bracket today, but expect to be in the 12% bracket in retirement. In this scenario, every dollar you defer is a dollar that gets taxed nearly half as much, although individual results will vary. Just as importantly, however, this frees up more capital that can potentially benefit from decades of compound growth.

Traditional IRAs and 401(k)s are the workhorses here, letting you invest more than $30,000 of income before it gets taxed. In the case of traditional IRAs, it should be noted, those tax benefits phase out at certain income levels.

Beyond capped retirement accounts, two strategies can help you maximize the benefits of deferring taxes:

• Tax-loss harvesting can sprinkle the same advantages on a portion of your taxable investing, with theoretically no limits—and as a side benefit, any leftover harvested losses can offset a higher tax on up to $3,000 of ordinary income each year.
• Asset location, also known as Tax Coordination at Betterment, can help shield more of your tax-heavy assets in tax-deferred accounts.

Both features are fully-automated at Betterment and just a few of the ways it can pay to automate your investing.

Filling up low brackets: Take advantage of low or no(!) tax rate years

If deferring taxes is about pushing taxes into the future, the second type of tax swap is its polar opposite: pulling them forward into the present when your cash flow dips below its normal cruising altitude. Think early in your career, a gap year between jobs, or early retirement.

Filling up low brackets strategically requires advance planning, which is why we recommend talking things through with both a financial and tax advisor. Broadly-speaking, you have a few strategies at your disposal:

• Roth IRA/401(k) contributions | Paying taxes on your investing now so future growth can be tapped tax-free via qualified withdrawals.
• Roth IRA conversions | Converting pre-tax traditional IRA/401(k) contributions to a Roth IRA and paying taxes now.
• Tax-gain harvesting | Strategically selling appreciated investments in a taxable account to realize gains without owing federal income tax, then reinvesting the proceeds.

If you play your cards right here, you could pull off the most impressive tax swap of all: a 0% tax rate.

That’s thanks to the favorable treatment of long-term capital gains, the profits from selling investments held longer than a year. Unlike short-term gains, which are taxed as ordinary income, long-term gains have their own brackets, which are both lower and fewer in number:

Tax year 2026 long-term capital gains tax rates

Source: IRS

This means investors, assuming they have no other sources of income, can enjoy tens of thousands of dollars in qualified tax-free profits from their taxable investing accounts each year, and even more when factoring in the standard deduction.

How Betterment makes it easy

You could map all of this out yourself—figuring out your current bracket/s, projecting where you’ll land in retirement, deciding which accounts to prioritize, and revisiting it all every time your life changes. It’s doable. It’s also a lot.

Or you can let us do the lion’s share of the work. Tell us your household pre-tax income and tax filing status, and we’ll recommend whether it makes sense to lean into tax-deferred accounts.

And for even more personalized guidance, there’s Betterment Premium. Our team of advisors can help you think through the timing of Roth conversions and other strategies that benefit from a human eye. We also recommend looping in a tax advisor, who can pressure-test the plan from a tax filing perspective.

A savvy trade hiding in plain sight

Tax swaps aren’t about gaming the system. They’re about using the tax code the way it was designed to be used—strategically, patiently, and with an eye on the long game. Most investors leave this opportunity on the table not because it’s out of reach, but because it feels complicated.

It doesn’t have to be. Whether you’re just starting to think about tax-smart investing or looking to get more intentional about your retirement strategy, Betterment can help you find and act on the opportunities that make sense for you.