5 Tax Mistakes Investors Make That Drain Returns
Every year, investors make simple tax errors that cost real money. While knowledge of the tax code isn’t a prerequisite for being a good investor, understanding certain basic rules can go a long way toward preserving capital.
Here are some common investor mistakes when it comes to taxation.
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1. Selling One Day Too Early
A single day on the calendar can make the difference between a gain that is taxed at ordinary income rates and one that’s not taxable at all.
The IRS assigns special capital gains tax rates on assets held longer than one year. Depending on income, long-term capital gains tax rates can be 0%, 15% or 20%. However, any assets held for one year or less and sold at a gain are taxed as ordinary income, with rates currently as high as 37%.
Someone in the 37% tax bracket who sells a stock 11 months after buying it pays ordinary income rates on the gain. But if they wait one day past the one-year mark, they can take advantage of the 15% long-term capital gains rate. On a $10,000 gain, that amounts to a difference of $2,200 in additional taxes.
2. Triggering a Wash Sale
Selling an investment at a loss can be a good way to offset taxable gains, or even up to $3,000 in ordinary income. The problem comes if the same investor buys back the same or a “substantially identical” security within 30 days before or after the sale. Per IRS rules, this is known as a wash sale, and it prevents an investor from being able to deduct the loss.
An often overlooked aspect of this rule is that it applies across every account an investor owns, including IRAs and a spouse’s accounts, according to Vanguard. Even if the investor sells a losing stock in a taxable brokerage account and his or her spouse buys the same stock in an IRA within the 30-day window, that loss is still disallowed.
3. Missing a Required Minimum Distribution
Required minimum distributions are a fact of life if you have any pre-tax retirement accounts, such as a traditional IRA or 401(k). For years 2023 and later, the IRS says you must begin taking these minimum distributions from your account by April 1 of the year after you turn 73.
Account holders who fail to withdraw the full RMD by the deadline face an excise tax of 25% on the shortfall, although this can be reduced to 10% if the mistake is corrected within two years, according to the IRS. Someone who fails to take a $10,000 RMD, for example, will owe $2,500 in excise taxes, although that can drop to $1,000 if corrected within the two-year grace window.
But that’s not all. The account holder will also have to pay regular income tax on the distribution when it is finally taken. For someone in the 24% tax bracket, that would amount to $2,400 in income taxes on top of the initial $2,500 excise tax penalty.
4. Failing To Track Cost Basis on Reinvested Dividends
Investors who are paid dividends owe tax on the payments they receive, even if they are automatically reinvested into additional shares of a stock or a mutual fund. For tax purposes, each reinvestment counts as a brand-new purchase, with its own cost basis and holding period.
Failing to track those reinvestments as separate purchases can result in a problem at tax time. If you don’t have accurate records when you sell some or all of your shares, the IRS may assume that your cost basis is zero, per FINRA, leading to potentially much larger capital gains.
5. Not Matching Taxable Assets With Tax-Deferred Accounts
For maximum tax efficiency, each type of investment should be paired with the most tax-advantaged account. Tax-free municipal bonds, for example, do not need the tax deferral offered by accounts like IRAs and should instead reside in regular, taxable investment accounts. Dividend-paying stocks, interest-bearing bonds, and actively traded funds or stocks can benefit from sitting inside a tax-deferred account like a 401(k) or traditional IRA instead.
The location of an investment doesn’t change its return, but it can affect how much of that return gets taxed away before it ever compounds.
Editor’s note: Investing involves risk, including the possible loss of principal. Always consider your individual circumstances and consult with a qualified financial advisor before making investment decisions.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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