The Dow is again flirting with the 20,000 mark. It closed today at 19,974.62. The run-up has finally prompted you to evaluate your portfolio to make some year-end rebalancing and, of course, tax moves. Good for you.
But don't undermine that effort by making these tax mistakes.
1. Buying a tax bill: Timing is everything, especially when it comes to investments. If you buy a mutual fund just before it issues capital gains distributions, you've also bought yourself a tax bill. Worse, Morningstar's Christine Benz points out, by adding a holding to your taxable account before it makes a payout, you're subject to taxes on gains you weren't around to enjoy.
Similarly, note the tax experts at J.K. Lasser, if you buy stock just before it goes ex-dividend -- an ownership classification date that determines who owns the stock for payment and tax purposes -- you've purchased a taxable dividend with no real return from your investment. Typically, the value of the stock declines by the amount of the dividend that will be paid, so there's no financial gain but you still owe taxes on the dividend you'll receive.
2. Selling profitable holdings too soon: The beauty of the capital gains rate is that they typically are lower than your ordinary income tax rate. But the implicit and operational description of this tax benefit is long-term. This means that in order to get the lower capital gains tax rate -- which, depending on your income tax bracket, could be 0 percent, 15 percent or 20 percent -- you must have owned the asset you sell for more than a year. Sell too soon -- that's before you own it for at least one year and one day -- and any gain will be taxed at your regular rate, which could be as high as 39.6 percent.
3. Selling losing assets for the wrong reason: Yes, you can offset your capital gains, long- and short-term, by selling stocks that have lost value. But don't necessarily sell a losing asset just for tax reasons. Yes, I just typed that.
A down year doesn't necessarily mean that the asset is a bad investment. It could rebound and be a good long-term portfolio performer. So do your due diligence and thorough analysis of your assets before deciding to sell.
4. Ignoring the wash sale rule: Say you decide to sell a loser but want to keep that investment category within your portfolio. Be careful. If you acquire substantially identical securities within 30 days before or after the date that you sell/sold assets at a loss, the wash sale rule says you can't take the loss in the year of the sale.
This means you'll have to a bit more investment work, looking for a holding that's not substantially identical to replace the one you sold for tax reasons. J.K. Lasser suggests that, for example, if you sell a corporate bond at a loss, buy a bond with a similar maturity but issued by a different corporation, or a bond by the same corporation, but with a different maturity.
And don't, say Lasser experts, try to avoid the wash sale rule by selling at a loss in your taxable account and then using your IRA to buy the same security within the 30-day wash sale period. The loss in this case also is banned by the wash sale rule.
5. Converting too much to a Roth IRA: The removal in 2010 of the $100,000 income cap on the conversion of a traditional IRA to a Roth retirement account made this option much more appealing to many individuals. However, don't be so eager to convert to the tax-free Roth option that you end up undermining your nest egg.
If you don't have enough money from other sources to pay the conversion tax and must use some of the Roth IRA funds to do so, you lose the potential benefit of tax-free growth on that amount, defeating the purpose of converting. Don't let that deter you from converting. Just convert only that amount for which you can cover the tax bill.
Before deciding whether to convert any traditional IRA amount to a Roth, don't be lured simply by the tax-free possibility. Yep, I'm saying it again; taxes aren't always paramount when it comes to investments, both regular and retirement.
Make sure the IRA change is the right move for you by assessing not only the money you'll need to pay tax on the converted amount, but also your future tax bracket (as much as your crystal ball and possible tax law changes will allow), your time horizon for accessing the funds and your overall estate plans.
6. Missing the RMD deadline: If you do have money in a traditional IRA or other tax-deferred retirement account, when you turn 70½ you'll have to start taking some money out. The reason is that Uncle Sam has been waiting all these years for the tax on your nest egg. The Internal Revenue Service even has tables that, based on your age, tell you what percentage you must withdraw, known as required minimum distributions or RMDs, each year.
If you miss the RMD Dec. 31 deadline, you'll face a stiff tax penalty of 50 percent of what you should have withdrawn.
But be careful if you have multiple IRA accounts. You can't simply take the RMD amount from one IRA and not account for the others.
7. Overlooking the RMD charitable option: If you must take an RMD but don't need the money to live on, you have a special, specific charitable donation option. You can directly transfer your RMD amount, up to $100,000, to an IRS-qualified charity. You then will meet your RMD but because you donated it, it is not taxable to you. Note that this is possible only via a direct transfer, so set up the donation before the Dec. 31 deadline arrives.
8. Triggering the NII tax: If your modified adjusted gross income is over a certain amount, you'll face the additional 3.8 percent net investment income (NII) tax. The thresholds at which the tax kicks in are $250,000 for joint filers, $200,000 for singles and $125,000 for married persons filing separately. The thresholds are not adjusted for inflation. Be careful in deciding what investments to sell. The gains could put you over the NII threshold. In that case, it could be advisable to wait until the new tax year to make the transaction.
OK, one final time, I'll say that you shouldn't let tax considerations be the sole reason you make any investment move. However, don't overlook the tax implications, either.
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