Investment Tax Blunders to Avoid

If you can avoid the top ten investment blunders, you will save money on your taxes and perhaps even increase the returns on your investments. We realize that a mid-year review of your tax situation may not be at the top of your “to-do” list, but think of it this way: devoting a few minutes now could save you big bucks at tax time.

By following these tips, you can reduce your taxes for the year and even increase the after-tax return on some of your investments:

1. Anticipate distributions from declining funds - Since mutual funds are required to distribute capital gains to shareholders, you might receive a taxable distribution even though there was a decline in the share price of your fund this year. By preparing yourself and setting aside cash, you can avoid scrambling to pay taxes in April.

2. Purchase shares after the next scheduled distribution - Don’t buy a mutual fund shortly before a capital gains distribution since a portion of your investment will almost immediately be handed back to you. This will have you owing tax on the distribution with less money to reinvest.

3. Be prudent with “tax-exempt” investments - Although the income from “tax-exempt” investments is generally nontaxable, funds will sometimes throw off capital gains distributions. This happens when the fund managers sell bonds, which can produce a taxable capital gain, and then buy other bonds. This can aggravate fund investors who don’t expect to pay taxes on these types of investments.

In addition, if you want the income to be tax-exempt for state income tax purposes, you need to make sure the fund is invested in your resident state muni-bonds since most states treat as taxable muni-bond interest derived from other states. Another common mistake is failing to change funds when you move from one state to another.

If you are subject to the alternative minimum tax (AMT), be aware that interest from most “private activity” muni-bonds is tax-exempt for regular tax purposes but not for AMT purposes.

As part of the health-care related Affordable Care Act, the net investment income of higher income taxpayers is subject to the net investment income tax (NIIT), which is a 3.8% surtax on the lesser of their modified adjusted gross income that exceeds a filing-status based threshold amount or  their investment income less investment expenses. For surtax purposes, gross income doesn't include interest on tax-exempt bonds, which weighs in favor of owning tax-exempt bonds.

4. Time your fund transfers wisely - Frequently, people sell one bond fund or mutual fund to buy another as a way of rebalancing their portfolio. However, for tax purposes, that represents a sale of a security and the purchase of another. Thus, you will need to account for the gain or loss from the fund sold on your tax return. This is generally an unpleasant surprise to those unaware of this rule, especially if there is significant gain to report on the sale. If there is a loss, selling the fund during the current year will allow you to utilize the loss now (within the limits explained in #8 below). However, if there is a gain, consider waiting until just after the first of the year so that you can defer the gain---but this strategy may not be appropriate for someone who can take advantage of the 0% long-term capital gain tax rate.

5. Contribute the maximum - If you maximize your retirement plan contributions, it will help maintain your current lifestyle years from now. In addition, it may also reduce this year’s taxable income.

6. Say “no” to tax-free investments in tax-sheltered plans - Instead of concentrating on annuities or municipal bonds, you’ll do better with high-yielding income and growth-oriented investments.

7. Sell a loser - There probably isn’t a stock market investor who isn’t holding a stock that is worth less now than when it was bought. Selling a loser in a taxable account can save you money and free up cash for investments with more potential. This is because the IRS allows investors to offset realized gains with realized losses. In addition, $3,000 in additional losses can be used to reduce your taxable income. Don’t sell for tax reasons alone, especially if you are confident that your dogs will turn into dream stocks. Just keep in mind that if a stock has dropped in price by 50%, it will need to gain 100% in order to break even.

8. Be aware of the limit on losses - If you are thinking of cashing in all your dogs, consider that losses are limited to offsetting realized gains and up to $3,000 in ordinary income. Although losses higher than this amount can be carried over for use in the future, they would be of no benefit to you this year.

9. Stay away from wash sales - If you would like to offset gains with losses, try and avoid “wash sales” since the IRS doesn’t allow you to recognize the loss on such sales. A wash sale occurs when a security is sold at a loss and then repurchased within 30 days before or after the date it was sold.

Don’t fret. One way you can realize losses and keep your portfolio balanced is to sell and buy back a security 31 days after the sale. Individuals who cannot wait for that period of time should purchase a similar security (not identical) to the one that was sold.

10. Check your cost basis when you sell - Although most people remember to include commissions on trades or mutual fund transaction fees when calculating cost basis, many fail to consider the dividend money that has automatically been reinvested, which results in taxpayers overpaying on taxes. Most commonly dividend reinvestment occurs with mutual funds but some companies also have dividend reinvestment plans for individual stockholders. Reinvested capital gains and dividends can add quite a bit to cost basis and make gains much smaller.

Review all your purchases when it comes time to sell. You will have a smaller taxable gain and a much better idea of your actual return on a fund.

As an investor, you want what’s best for your money. Be prepared and avoid the unnecessary headache at tax time. If you have specific concerns regarding your investments, please call our office so we can discuss them in detail.

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