We all make mistakes. Sometimes, these mistakes are small, so it’s easier to recover from them and move on, determined to avoid the same mistakes in the future. Other mistakes can be costly and harder to recover from. When you invest, it’s important to avoid some of the big tax mistakes that can add up to thousands of dollars transferred from your pocket to the government.
In many cases, tax mistakes related to investment become bigger over time.
Not only are you missing the nominal amount you overpay in taxes, but you also miss out on the earnings you would have enjoyed on this money. A little careful planning now can help you avoid mistakes later.
Do You Have a Plan for Your Investment Gains?
When you sell an asset from a “regular” taxable investment account, you need to consider how this gain will impact your finances and your tax situation. “If it’s the right thing to sell, you should sell,” says David Richmond, the founder and President of Richmond Brothers, Inc. “Make a plan for that gain. Any tax you pay is money out of your pocket. Try to keep what you pay to a minimum as much as possible.”
Part of figuring out when to sell depends on how long you’ve held an asset. Long-term capital gains come with favorable tax treatment, while short-term gains are taxed as regular income. If you can sell long-term assets before you sell short-term assets, you can reduce your tax bill. It’s also possible to use capital losses to offset your capital gains.
If you sell something for a big gain, consider whether or not there are also some under-performing assets you want to unload. The losses can help offset the gains, reducing your tax bill.
Richmond also warns against underpaying when you realize a large investment gain. In many cases, investors take the gain, and they don’t pay taxes immediately. When tax time rolls around, they are surprised by an underpayment penalty. “When you have a large gain, you should talk to a tax professional and make some sort of a quarterly payment,” Richmond suggests.
You also need to prepare for taxes by understanding changing tax law, and how you might be affected. “One recent example of a change that caught many people by surprise is the 3.8 percent surcharge with Obamacare,” says Richmond. High earners are expected to pay an extra 3.8 percent on gains they make — on top of their regular capital gains taxes. “This provision took effect for tax year 2013, so many investors are surprised by the fact that they owe more in taxes than they thought they would have to pay.”
It makes sense to connect with a tax and investment professional at the beginning of the year to get an idea of what to expect so you can mitigate the situation throughout the year, rather than being stuck with the unfortunate reality at tax time, when it’s too late to take steps to reduce your taxable income or employ legal strategies to improve your tax efficiency.
Retirement Investing and Tax Mistakes
Richmond points out that many investors make a lot of their tax mistakes when it comes to their retirement accounts. Before making a move with your retirement account, it makes sense to check with a professional who understands taxes and investing.
“One of the most common mistakes happens when people want to convert to a Roth IRA,” says Richmond. “They don’t realize that there are taxes owed on those conversions. If you convert $20,000, you owe taxes upfront on that money, and it is taxed as regular income.” He suggests contributing to a 401(k) to offset some of the income with a deduction, or to increase your tax withholding so you are prepared for the bigger tax bill.
Another issue, Richmond says, is people don’t pay attention to what happens with a 60-day rollover or loan from an IRA. “You have to put that money back, and the government is really particular about putting that money back within 60 days.”
If you don’t put the money back, it’s considered an early distribution and the appropriate taxes and penalties are charged against you.
It’s also important to realize if you have taxes withheld, you still need put the entire amount back within 60 days. “You might withdraw $10,000, but if you have 15% in taxes withheld, you’ll only receive $8,500,” Richmond says. “You have to put the entire $10,000 back. People get confused because they only received $8,500, but the reality is they withdrew $10,000 and the money needs to be put back into the IRA to be penalty-free.” He points out you can get a refund for taxes you prepaid on the money, but it has to be done after the fact.
“Early retirement can also lead to mistakes,” Richmond says. “I’ve had clients who retire at 55 and think they can tap their tax-advantaged retirement accounts.” This isn’t the case. You need to be 59 1/2 before you can get this money penalty-free.
You could end up paying thousands in fees, taxes, and penalties if you start withdrawing money during your early retirement. And don’t forget about Required Minimum Distributions (RMDs) when you reach age 70 1/2. Not planning for these forced withdrawals from your account can cost you big as you reach the final years of your life.
“You have to look at retirement account money as a joint venture with silent partner Uncle Sam,” Richmond continues. “They create the rules, and when you have $1 million in a retirement account, it’s only worth that minus taxes. You need to figure out the best way to get it out.”
Diversify Your Investment Accounts
In order to avoid some of the mistakes that come with investing for the long term, Richmond suggests you keep your money in multiple accounts with different rules.
“You want to diversify your tax status,” he says. “You need to have a mix of Roth and deferred accounts, as well as consider joint accounts and trusts. The way you manage these accounts can keep you in the lowest possible bracket.”
Richmond suggests you look for an investment advisor who is educated about tax implications, even if he or she doesn’t actually handle the tax end. “You need to build out your team. Have a tax professional on your team, as well as an investment advisor, and make sure that they can work together.”