The end of the year may be a beneficial or a dangerous time for investors. Avoiding the top 10 investment mistakes will save you money on your taxes in the long run, and possibly increase the returns on your investments.
A review of your year-end tax situation may not be at the top of your fall “to-do” list, but devoting a few minutes now could save you money at tax-time. The following tips may help you reduce your taxes in April and possibly help you increase the after-tax return on many of your investments.
1. Distributions from funds that have declined in value may be expected.
Capital gains from mutual funds must be distributed to their shareholders. This means that even though the share price of the fund has declined, you may still receive a taxable distribution. Be prepared to set aside money so that you won’t be forced to scramble to pay taxes in April.
2. Avoid investing in mutual funds before capital gains are distributed.
If a mutual fund is purchased shortly before a capital gains distribution, part of your investment will almost immediately be handed back to you. This will result in you owing tax on the distribution and have less money to reinvest. Try asking the fund company the date of the next scheduled distribution and be sure that the purchase is made after that date.
3. Manage “tax-exempt” investments wisely.
Many individuals do not realize that the manager buying and selling within the portfolio causes a lot of the total return on tax-exempt funds. This may be annoying to individuals who don’t expect to pay taxes on their tax-exempt investments. While interest payments from municipal bonds may be tax-exempt, capital gains distributions are not. The same applies to gains on the sale of a municipal bond and a municipal bond fund shares. Any realized gains are taxable on these funds.
4. Consider the timing of fund transfers.
You may be thinking that selling one bond fund to purchase another is just a way of rebalancing your portfolio, but the IRS will view the sale as a capital gains transaction. The tax may be postponed by transferring between funds after December 31st, but if you have already committed to making the transfer this year, be prepared to withhold part of the sale proceeds to pay taxes on the gain.
5. Max out your retirement plan contributions.
Contributing the maximum to a tax sheltered retirement plan now will not only help maintain your lifestyle in the future, butt may also help in the present by reducing this year’s taxable income.
6. Steer clear of tax free investments in tax sheltered plans.
In a tax sheltered plan, interest, dividends and capital gains grow tax free, so you’ll do better if you concentrate on high yielding income and growth oriented investments rather than annuities or mutual funds.
7. Don’t hold on to poor investments.
We don’t like to admit to mistakes, but the fact is that selling a loser in a taxable account may save you money and free up cash for better investments. The IRS allows investors to offset realized gains with realized losses. You may use up to $3,000 in additional losses to reduce your taxable income.
If you think that your poor investments will turn into dream stocks, you should of course not sell for tax purposes only. Keep in mind that a stock that has dropped 50% in price needs to gain 100% just to break even.
8. Know the limit on losses.
Keep in mind that before you cash in all of your poor investments, losses are limited to offsetting realized gains and up to $3,000 in ordinary income per year. Any losses above $3,000 may be carried over for use in future years.
9. Avoid wash sales.
Be sure to avoid “wash sales” if you would like to offset gains with losses. A wash sale occurs when you sell a security at a loss and repurchase the same security within 30 days (before or after) the date you sold. The IRS forbids using these types of losses to offset gains.
There are different ways that you may still realize losses and keep your portfolio in balance. You may sell and buy back a security 31 days after the sale. Or if you can’t wait 31 days, you may purchase a security that is similar but not identical to the one you sold. You may also replace a large-cap growth fund with a different large-cap growth fund or a stock in one computer company with a stock in different computer company.
10. Don’t underestimate your cost basis when you sell.
When calculating cost basis, most individuals only remember to factor in commissions on trades or mutual fund transactions fees. You also need to remember money that has already automatically been reinvested.
When it’s time to sell, be sure to review all of your purchases carefully, and don’t forget to include the purchase of 1.4563 shares with $12 of reinvested dividends. You will end up with a smaller taxable gain and a better idea of your actual return.
