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.
About
the Author
David Twibell is President and Chief Investment Officer of Flagship
Capital Management, LLC, an investment advisory firm in Colorado Springs,
Colorado. Flagship provides portfolio management services to high-net-worth
individuals, corporations, and non-profit entities. For more information,
please visit www.flagship-capital.com.
