For many investors, and even some tax professionals, going through the complex IRS rules on investment taxes can be a nightmare. Cheats abound, and the penalties for even simple mistakes can be severe. As April 15 approaches, keep in mind the following five common tax mistakes and help yourself keep a little more money in your own pocket.
1. Not Compensating Earnings
Normally, when you sell an investment for a gain, you must pay tax on the gain. One way to reduce that tax burden is to also sell some of your losing investments. You can then use those losses to offset your gains.
Let’s say you have two actions. You have a profit of $1,000 on the first action and a loss of $1,000 on the second. If you sell your winning shares, you will owe tax on the $1,000 gain. But if you sell both shares, your $1,000 gain will be offset by your $1,000 loss. That’s good news from a tax standpoint, as it means you don’t have to pay any tax on any position.
Sounds like a good plan, right? Well, it is, but keep in mind that it can be a bit tricky. Under what is commonly called the “sound sale rule,” if you repurchase losing shares within 30 days of the sale, you cannot deduct your loss. In fact, you are not only prevented from buying the same stocks again, you are prevented from buying stocks that are “substantially identical” to them, a vague phrase that is a constant source of confusion for investors and trading professionals alike. taxes. Finally, the IRS requires that you must first compare long-term and short-term gains and losses against each other.
2. Miscalculating the basis of mutual funds
Calculating the gain or loss 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 profit or loss is the difference between your basis and the net proceeds from the sale. However, it gets a lot more complicated when it comes to mutual funds.
When calculating your basis after selling a mutual fund, it’s easy to forget to account for the dividend and capital gains distributions you reinvested in the fund. The IRS treats these distributions as taxable earnings in the year in which they are made. As a result, you have already paid taxes on them. If you don’t add these distributions to your basis, you’ll end up reporting a larger profit than you received from the sale, and ultimately paying more tax than necessary.
There is no easy solution to this problem, other than keeping good records and being diligent in organizing your distribution and dividend information. The extra paperwork can be a headache, but it could mean extra money in your wallet at tax time.
3. Do not use tax-administered funds
Most investors keep their mutual funds for the long term. That is why they are often surprised when they receive a tax bill for the short-term gains made by their funds. These gains are the result of the sale of shares held by a fund for less than a year and are passed on to shareholders to report their own returns, even if they never sold their mutual fund shares.
Recently, more mutual funds have focused on effective tax management. These funds try not only to buy shares in good companies, but also to minimize the tax burden on shareholders by holding those shares for long periods of time. By investing in tax-refund-oriented funds, you can increase your bottom line and save yourself some tax-related headaches. However, to be worthwhile, a tax-efficient fund must have both ingredients: good investment returns and low taxable distributions to shareholders.
4. Missing deadlines
Keogh plans, Traditional IRAs and Roth IRAs are great ways to stretch your investment dollars and provide for your future retirement. Unfortunately, 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 IRAs, you have until April 15 to make contributions. Mark these dates on 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, like an IRA or 401(k), and traditional. What many people don’t realize is that having the right kinds of assets in each account can save them thousands of dollars each year in unnecessary taxes.
In general, investments that produce a lot 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, suppose 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 finally sold, which will also be taxed at 15% or less. Consequently, since these shares already have favorable tax treatment, it is not necessary to house them in a tax-advantaged account.
By contrast, most Treasury and corporate bond funds produce a steady stream of interest income. Since this income doesn’t qualify for special tax treatment like dividends, you’ll have to pay tax on it at your marginal rate. Unless you’re in a very low tax bracket, having these funds in a tax-advantaged account makes sense because it allows you to defer these tax payments in the future, or possibly avoid them altogether.