In fact, many investors pay more taxes than they need to. We are going to list seven common tax-related mistakes investors make. (Please note that the same things may not be mistakes if they are done within a tax-sheltered account such as an IRA or 401(k) plan.)
1. Load relief
We’ll start with a mistake — actually a missed opportunity — that many people have never thought of. Investors who buy front-end load funds fail to get the IRS to underwrite part of the sales commissions. We steadfastly recommend no-load funds, but we know many investors buy load funds anyway. And those who pay front-end commissions in taxable accounts can get back part of their money through the tax code. However, very few do it. Here’s how it works. Say you invest $10,000 in a fund that charges a 5.75 percent load, or $575. The day after you open the account, it’s worth only $9,425 (assuming no change in the net asset value per share). That means you’ve taken a $575 capital loss. If you sell the fund at that point, the loss can reduce your taxes by offsetting either capital gains or ordinary income (though the latter benefit is limited to $3,000 per year). Of course selling defeats the purpose of buying, and you’ll run into the “wash sale” rule that prohibits deducting a capital loss on an asset that you repurchase within 30 days. The solution: Identify the fund you want to own, then start by buying a different but similar fund in the same family. Keep this “temporary” fund long enough to avoid any early-redemption penalty, then take the loss and reinvest the proceeds in your target fund without paying a new load. At tax time, you’ll recover part of the $575 load.
2. Tax-managed funds
Investors buy mutual funds with high portfolio turnover and therefore receive recurring taxable gains distributions. Even if those distributions are reinvested (the most common arrangement), they are taxable. The tax must be paid either by selling some shares or from other income, which is the equivalent of investing new money. The solution is easy: Use tax-managed funds, tax-managed index funds and regular index funds whenever possible.
3. Basis calculations
When reporting capital gains (or losses) from mutual fund sales, many people fail to include in their basis the dividends and capital gains distributions that they have reinvested. The result is that they report (and pay taxes on) larger gains (or smaller losses) than they actually have. The solution is to keep good annual records of such things. Most mutual funds now provide average cost statements that are very helpful. Investors who sell zero-coupon bonds should also make sure they aren’t reporting gains on which they have already paid taxes.
4. Right asset, wrong account
Millions of investors pay unnecessary taxes because they incorrectly allocate assets between their taxable and tax-sheltered accounts. Here’s the general rule: As much as possible, tax-efficient assets should be held in taxable accounts, and tax-inefficient ones should go into tax-sheltered accounts. Taxable bond funds are very tax-inefficient because they generate regular income taxable at ordinary rates. They belong in tax-sheltered accounts. Equity funds — especially index funds — are relatively tax-efficient because most of the income from them can be managed by timing sales. They belong in taxable accounts.
5. Sock it away
Investors fail to maximize their opportunities to shelter long-term investments in 401(k) and IRA accounts. The Roth IRA is such a tremendous deal, especially for young people, that it’s hard to understand why so many investors pass up decades of tax-free income. Likewise, far too many workers fail to contribute enough of their income to earn the matching money available from their employers in 401(k) plans. This is tantamount to turning down a raise in pay.
6. Don’t borrow
Too many working people borrow against their 401(k) plans. The loans may seem like a reasonable deal. The interest you pay goes right into your account. But if for any reason you leave your employment before the loan is repaid — and this includes layoffs — the balance of the loan is immediately payable in full, probably at the time when you are least able to afford it. Unpaid loan balances become taxable income, and if you’re under 59 1/2 , you’ll pay a 10 percent penalty to boot. In addition, you can’t ever put that money back later, even if you get a high-paying job.
7. When opportunity knocks
Too many investors overlook the possibility that they might get a higher after-tax yield from tax-exempt funds than from taxable ones. For several months, Vanguard’s Tax-Exempt Money Market Fund has had a higher yield than its taxable Prime Money Market Fund. Why pass up such an opportunity? Our country’s tax laws are complex, and everybody’s situation is potentially different. But I can make one blanket recommendation: Sometime after April 15, take a copy of this article to your CPA or other tax advisor and ask for a review of whatever tax mistakes you might be making. That will be time well spent. And if you find that you’re already doing everything right, you deserve to treat yourself to something special — especially if you can find a way to write it off!