Investors:
Avoid These 5 Common Tax Mistakes
by: David Twibell
For many investors, and even some tax
professionals, sorting through the complex IRS rules
on investment taxes can be a nightmare. Pitfalls
abound, and the penalties for even simple mistakes
can be severe. As April 15 rolls around, keep the
following five common tax mistakes in mind – and
help keep a little more money in your own pocket.
1. Failing To Offset Gains
Normally, when you sell an investment for a
profit, you owe a tax on the gain. One way to lower
that tax burden is to also sell some of your losing
investments. You can then use those losses to offset
your gains.
Say you own two stocks. You have a gain of $1,000
on the first stock, and a loss of $1,000 on the
second. If you sell your winning stock, you will owe
tax on the $1,000 gain. But if you sell both stocks,
your $1,000 gain will be offset by your $1,000 loss.
That’s good news from a tax standpoint, since it
means you don’t have to pay any taxes on either
position.
Sounds like a good plan, right? Well, it is, but
be aware it can get a bit complicated. Under what is
commonly called the “wash sale rule,” if you
repurchase the losing stock within 30 days of
selling it, you can't deduct your loss. In fact, not
only are you precluded from repurchasing the same
stock, you are precluded from purchasing stock that
is “substantially identical” to it – a vague phrase
that is a constant source of confusion to investors
and tax professionals alike. Finally, the IRS
mandates that you must match long-term and
short-term gains and losses against each other
first.
2. Miscalculating The Basis Of Mutual Funds
Calculating gains or losses from the sale of an
individual stock is fairly straightforward. Your
basis is simply the price you paid for the shares
(including commissions), and the gain or loss is the
difference between your basis and the net proceeds
from the sale. However, it gets much more
complicated when dealing with mutual funds.
When calculating your basis after selling a
mutual fund, it’s easy to forget to factor in the
dividends and capital gains distributions you
reinvested in the fund. The IRS considers these
distributions as taxable earnings in the year they
are made. As a result, you have already paid taxes
on them. By failing to add these distributions to
your basis, you will end up reporting a larger gain
than you received from the sale, and ultimately
paying more in taxes than necessary.
There is no easy solution to this problem, other
than keeping good records and being diligent in
organizing your dividend and distribution
information. The extra paperwork may be a headache,
but it could mean extra cash in your wallet at tax
time.
3. Failing To Use Tax-managed Funds
Most investors hold their mutual funds for the
long term. That’s why they’re often surprised when
they get hit with a tax bill for short term gains
realized by their funds. These gains result from
sales of stock held by a fund for less than a year,
and are passed on to shareholders to report on their
own returns -- even if they never sold their mutual
fund shares.
Recently, more mutual funds have been focusing on
effective tax-management. These funds try to not
only buy shares in good companies, but also minimize
the tax burden on shareholders by holding those
shares for extended periods of time. By investing in
funds geared towards “tax-managed” returns, you can
increase your net gains and save yourself some
tax-related headaches. To be worthwhile, though, a
tax-efficient fund must have both ingredients: good
investment performance and low taxable distributions
to shareholders.
4. Missing Deadlines
Keogh plans, traditional IRAs, and Roth IRAs are
great ways to stretch your investing dollars and
provide for your future retirement. Sadly, millions
of investors let these gems slip through their
fingers by failing to make contributions before the
applicable IRS deadlines. For Keogh plans, the
deadline is December 31. For traditional and Roth
IRA’s, you have until April 15 to make
contributions. Mark these dates in your calendar and
make those deposits on time.
5. Putting Investments In The Wrong Accounts
Most investors have two types of investment
accounts: tax-advantaged, such as an IRA or 401(k),
and traditional. What many people don’t realize is
that holding the right type of assets in each
account can save them thousands of dollars each year
in unnecessary taxes.
Generally, investments that produce lots of
taxable income or short-term capital gains should be
held in tax advantaged accounts, while investments
that pay dividends or produce long-term capital
gains should be held in traditional accounts.
For example, let’s say you own 200 shares of Duke
Power, and intend to hold the shares for several
years. This investment will generate a quarterly
stream of dividend payments, which will be taxed at
15% or less, and a long-term capital gain or loss
once it is finally sold, which will also be taxed at
15% or less. Consequently, since these shares
already have a favorable tax treatment, there is no
need to shelter them in a tax-advantaged account.
In contrast, most treasury and corporate bond
funds produce a steady stream of interest income.
Since, this income does not qualify for special tax
treatment like dividends, you will have to pay taxes
on it at your marginal rate. Unless you are in a
very low tax bracket, holding these funds in a
tax-advantaged account makes sense because it allows
you to defer these tax payments far into the future,
or possibly avoid them altogether. |
