INVESTORS: AVOID THESE 5 COMMON TAX MISTAKES
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 û 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 û 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.
__________________________________________________________
David Twibell is President and Chief Investment Officer of
Flagship Investment Management/LLC, a leading registered
investment advisory firm in Scottsdale, Arizona. Flagship
provides investment management services to high net worth
individuals, corporations, and non-profit entities.
