For many investors, and even some tax professionals, sorting through complex IRS rules on investment taxes can be a nightmare. Pitfalls abound, and penalties for even simple mistakes can be severe. As April 15 rolls around, keep following five common tax mistakes in mind – and help keep a little more money in your own pocket. 1. Failing To Offset Gains
Normally, when you sell an investment for a profit, you owe a tax on gain. One way to lower that tax burden is to also sell some of your losing investments. You can then use those losses to offset your gains.
Say you own two stocks. You have a gain of $1,000 on first stock, and a loss of $1,000 on second. If you sell your winning stock, you will owe tax on $1,000 gain. But if you sell both stocks, your $1,000 gain will be offset by your $1,000 loss. That's good news from a tax standpoint, since it means you don't have to pay any taxes on either position.
Sounds like a good plan, right? Well, it is, but be aware it can get a bit complicated. Under what is commonly called "wash sale rule," if you repurchase losing stock within 30 days of selling it, you can't deduct your loss. In fact, not only are you precluded from repurchasing same stock, you are precluded from purchasing stock that is "substantially identical" to it – a vague phrase that is a constant source of confusion to investors and tax professionals alike. Finally, IRS mandates that you must match long-term and short-term gains and losses against each other first.
2. Miscalculating The Basis Of Mutual Funds
Calculating gains or losses from sale of an individual stock is fairly straightforward. Your basis is simply price you paid for shares (including commissions), and gain or loss is difference between your basis and net proceeds from sale. However, it gets much more complicated when dealing with mutual funds.
When calculating your basis after selling a mutual fund, it's easy to forget to factor in dividends and capital gains distributions you reinvested in fund. The IRS considers these distributions as taxable earnings in year they are made. As a result, you have already paid taxes on them. By failing to add these distributions to your basis, you will end up reporting a larger gain than you received from sale, and ultimately paying more in taxes than necessary.
There is no easy solution to this problem, other than keeping good records and being diligent in organizing your dividend and distribution information. The extra paperwork may be a headache, but it could mean extra cash in your wallet at tax time.
3. Failing To Use Tax-managed Funds
Most investors hold their mutual funds for long term. That's why they're often surprised when they get hit with a tax bill for short term gains realized by their funds. These gains result from sales of stock held by a fund for less than a year, and are passed on to shareholders to report on their own returns -- even if they never sold their mutual fund shares.