The Worst Investment Strategies You Can Make from a Tax Standpoint

Needless to say, income taxes can be a big bite. On the other hand, the performance of your overall investment portfolio is obviously important. And, it may be good or bad. But, which is more important – saving income taxes or protecting the overall future of your portfolio by taking some chips off the table now. Do you cash-in your investment now knowing that income taxes may be as low as 0%, or as high as somewhere between 23.8% to 43%. Or, do you risk missing out on an investment gain by failing to cash in because you can’t bring yourself to write an “income tax” check? This answer varies by individual. Each person may have a VERY different tax situation in terms of other income and expenses, loss carryforwards, capital loss carryforwards, credit carryforwards, amount of estimated taxes paid, AMT, NIIT, additional Medicare tax, social security benefits – just to mention a few off the cuff. The other side of the coin is that individuals also have significantly different investment holdings. Both factors may be huge considerations – one cannot be simply ignored to the exclusion of the other. 

The article that follows goes into greater depth and covers several examples of what may be considered poor tax planning.

1.     Selling stock too soon.  Capital gains on holdings of more than a year are taxed favorably at rates from zero for those in the lowest bracket to 23.8% for those in the highest individual rates. Efforts should be made, if possible, to retain stocks for at least one year to get the favorable rates.
2.    Not realizing losses when there are taxable gains.  In years that you have taxable gains, you should try to offset taxes as much as possible by realizing losses embedded in your portfolio and selling some of those shares.
3.    Having losses offset the wrong type of capital gains.  If there is a choice, it is better to offset short term gains with long term losses. This way, you will get the full benefit of the loss against income that would be taxed at regular rates. Offsetting long-term gains with short-term losses wipes out income that would have been taxed favorably. This strategy requires some advance calculations and planning.
4.    Not carrying forward capital losses.  Capital losses can offset capital gains with up to $3,000 of losses in excess of gains used to offset other income. Losses not deductible can be carried forward indefinitely until used up, at amounts of $3,000 per year.
5.    Thinking that a surviving spouse can utilize capital losses.  Carried-forward capital losses disappear at death and cannot be used by a surviving spouse who previously filed a joint return if those losses are not attributed to him/her.
6.    Not properly utilizing losses on options trades.  Those that trade in stock options and have losses can offset these against capital gains. If options are sold, income is not recognized until they are repurchased at a gain or expire. If the options are exercised, the amount received is added to the sale price of the shares. If you buy options and exercise them, their cost is added to the purchase price of the acquired shares.
7.    Unintentionally creating a wash sale.  People who trade and have losses and then reacquire shares in the same company within 30 days before or after selling them will have a “wash” sale and cannot recognize the loss. They need to be careful of falling into this trap. See point #8 below for a way to avoid the wash sale rules.
8.    Not harvesting losses.  People with tax losses can harvest these losses to be used currently or in future years without running afoul of the wash-sale rules. This is done by selling the loss shares and immediately buying shares in similar companies so that the market risk hasn’t changed. An example is to sell shares in a certain sector and buy the exchange traded fund (“ETF”) for that sector…hold it for 31 days…and then sell that and repurchase the prior shares that were sold. This puts your portfolio in the same position as before the first sale, but you have the losses to offset current or future capital gains. You can also do this with mutual funds and index funds, not just ETFs. Your risk is that the substituted funds or ETFs don’t perform similarly during that 31-day period as the individual stock you sold.
9.    Putting stocks in children’s names and then selling them.  People who put stocks in their children’s names will not get any tax benefit because, except for minimal amounts, the Kiddie tax will be at the same rates as the parents (As of 2018, Kiddie Tax is now taxed at the trust rates). But this can be done with other people you might be supporting, such as an elderly parent. Caution:  Watch for interactions on their returns that need to be factored in, such as triggering a tax on Social Security benefits.
10.    Owning publicly traded partnerships (“PTP”) in retirement accounts.  Certain types of income from PTPs are considered “unrelated business taxable income” and are subject to taxation even though they are in a tax-deferred or tax-advantaged account, such as an IRA, Roth IRA or 401(k). Also, owning PTPs in your own name can increase your tax preparation fee, since many of these entities issue multiple-page K-1s (up to 10 pages) rather than a single-page 1099.
11.    Buying tax-free government bonds when their earnings will result in higher tax payments. People who buy tax-free government bonds to avoid federal income tax can still be subject to the Alternative Minimum Tax if the bonds are for private activities…or returns from these bonds can trigger a tax on Social Security benefits. You have to run the numbers.
12.    Wrong asset location.  Many investors have stock in their tax-deferred accounts, and tax-exempt bonds in their own names. But income earned in a tax-deferred account, such as an IRA or 401(k), is taxed as ordinary income when distributed, regardless of the nature of the income in the IRA—this means capital gains and dividends would lose their beneficial rates. A better way is to have the tax-deferred account own corporate bonds and keep stock in your personal accounts. The overall yield will increase since corporate bonds pay higher interest than tax-exempt bonds, and the stock will provide capital gains and dividends that will be favorably taxed. Also, unrealized stock appreciation will never be taxed if owned at death.
13.    Not using retirement accounts for active trading.  Tax-deferred accounts should be used by active traders who generate extensive short-term gains or if they trade or sell options. Active traders who have IRAs or self-directed retirement accounts should not overlook doing this.
14.     Investing in mutual funds at the wrong time of the year.  Many mutual funds declare and pay their capital gains dividends for the year in December. Buying such shares in November or December could cause you to pay tax on money you are receiving back from what you just invested. You then pay tax on your own money rather than on earnings.

As I always say, taxes are complicated and need an understanding to not fall into traps or to have you engage in costly strategies. These strategies can help you avoid or minimize your taxes from investing transactions. It’s always wise to review your investment strategies with a tax adviser and not just your investment adviser.

Credit to Edward Mendlowitz, CPA, ABV, PFS (Money, September 15, 2017)

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