Investors: Avoid These 5 Common Tax
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
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
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
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 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.
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