For most investors, and even certain tax accountants, sorting through the multifaceted IRS rules on investment taxes can undoubtedly be a nightmare. Drawbacks abound, and the consequences for even simple errors and faults can be severe. As April 15th rolls around, ensure that you keep these 5 common tax mistakes in mind.
1. Failure to Offset Gains
Usually, when you manage to sell an investment for a profit, you are supposed to pay a tax on the gain. One of the best way to lower that tax load is to also sell some of the losing investments. You can then comfortably use those losses to counterbalance your gains.
Let’s say you have two stocks. On the first stock, you have a gain of $1000, and on the second stock you have a loss of $1000. If you manage to sell your winning stock, you will definitely owe tax on the $1,000 gain. But in case you sell both stocks, your gain ($1000) will be offset by your loss ($1,000). That is great news from a tax standpoint, because it means you will not have to pay any taxes on either position.
This sounds like a good strategy, right? Well, it actually is, but be mindful, it can get a bit complex. Under what is commonly referred to as the "wash sale rule," whereby if you repurchase the losing stock within thirty days of selling it, you cannot deduct your loss. As a matter of fact, not only are you prohibited from repurchasing that same stock, you are prohibited from purchasing stock that is "considerably identical" to it - an imprecise phrase that is always a source of confusion to tax professionals and investors alike. Lastly, the Internal Revenue Service demands that you must match short-term and long-term losses and gains against each other first.
2. Failing To Use Tax-managed Funds
It is clear that most investors choose to hold their mutual funds for the long term. That is the reason why they are often shocked when they eventually get hit with a tax bill for short-term gains realized by their investment. These gains are normally as a result of sales of stock held by a certain fund for less than one year, and are then passed on to stockholders to report on their personal returns – even when they never sold their mutual fund shares.
Lately, more mutual funds have been concentrating on proper and effective tax-management. All these funds try to not only reduce the tax burden on stockholders by holding those shares for prolonged periods of time but also purchase shares in good companies. By simply investing in funds steered towards "tax-managed" returns, individuals can upsurge their net gains and save themselves some tax-related problems. To be worthy, though, a tax-efficient fund needs to have both ingredients: low taxable distributions and good investment performance.
3. Miscalculating the Basis of Mutual Funds
Calculating losses or gains from the sale of a particular stock is rather straightforward. Your basis is just the price you paid for the shares - including the commissions-, and the loss or gain is the difference between the net proceeds from the sale and your basis. But it gets much more complex when handling mutual funds.
When you are calculating your basis right after selling a mutual fund, it is very easy to forget to include the capital gains and dividends distributions you re-invested in the fund. The Internal Revenue Service (IRS) normally considers all these distributions as taxable earnings. Consequently, you have already paid the taxes on them. By not adding these distributions to your basis, you will possibly end up reporting a larger gain compared to whatever you received from the sale, and eventually paying more in taxes than required.
It is important to know that there is no simplified solution to this particular problem, other than being diligent in organizing your distribution and dividend information and keeping good records. The additional paperwork may be a nuisance, but it can also mean extra cash in your pocket at tax time. As a matter of fact getting a professional tax preparer for this particular issue could be very helpful.
4. Putting Investments in the Wrong Accounts
A good number of investors have two main types of investment accounts: traditional account and tax-advantaged, like 401(k) or an IRA. What most people don’t actually realize is that holding the right assets in each and every account can greatly save those thousands of dollars each single year in preventable taxes.
In general, investments that produce a lot of short-term capital gains or taxable income should only be held in tax advantaged accounts, whilst investments that produce long-term capital gains or pay dividends should only be held in traditional accounts.
For instance, let us say you own about 200 shares of Duke Power, and plan to hold the shares for many years to come. This investment will definitely generate a quarterly brook of dividend payments, that will be taxed at about 15% or even less, and a long-term capital loss or gain once it is sold, which will simply be taxed at roughly 15% or less. As a result, because these shares already have an auspicious tax treatment, there is actually no point of sheltering them in a tax-advantaged account.
In contrast, most corporate and Treasury bond funds produce a stable stream of interest income. Because this particular income does not meet the requirements for special tax treatment like dividends, you will be forced to reimburse all the taxes on it at your marginal rate. Except when you are in a tax bracket that is very low, holding these particular funds in a tax-advantaged account actually makes sense since it permits you to possibly avoid them or defer these tax payments into the future.
To avoid all these mistakes, make sure you always take advice from professionals. To find a tax professional is not an easy task and that’s why I’m here for you. I will make sure I guide you through the rules and regulations of IRS to avoid any kind of tax mistake.
Kevin J May CPA