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Welcome to Get Smart about Investing. Let’s look at the most common mistakes that individuals make regarding the taxation of investments.
1. Not knowing the cost basis
Very few investors actually know the cost basis of their investments. As a result, they are making investment decisions without considering one of the key factors - the tax consequences. It can make a big difference if you are selling a position that has a loss or gain. Professional portfolio managers will often make investment decisions that offset gains and losses to minimize the tax an investor is subject to each year.
2. Not considering the holding period
What if you had invested $20,000 11 months ago and your investment had grown to $40,000? If you sold today, your holding period would be less than one year and as a result, you would have to pay the higher, short-term capital gains rates. If you held onto the shares one extra month, you could convert short-term gains into long-term gains, thus saving on taxes.
3. Making taxes the primary focus in decision-making
On the other hand, you never want to make investment decisions solely due to taxes. I have met many investors who never sold an investment because they didn’t want to pay taxes; and all too often the result is holding onto investments of lesser quality simply to avoid taxes. Always factor in taxes, but do not let taxes dictate your investment decisions.
4. Getting upset about losses and forgetting about them
No one likes to have losses, and some people, after experiencing them, get really upset and tend to have an out of sight, out of mind perspective. This happened a lot in 2001 and 2002, when many stock investors suffered significant losses. If you experienced losses, you need to keep track of them, so at the very least, you can reduce your taxes ny deducting losses against your income. Again, I never want to experience losses, but if I do, I definitely want to use them on my taxes as a way of reducing their impact.
5. Buying mutual funds right before their distribution dates
Mutual funds usually make their distributions once or twice a year, most often in November or December. If you own the shares prior to the distribution, you will probably have to pay some tax on whatever the distribution amount is. The challenge is that you might be subject to taxes on an investment even though you did not receive any gain. This can be fairly complicated to understand and represents one of the disadvantages of mutual funds from a tax perspective. Always ask the mutual fund company when their distribution dates are prior to buying, particularly in November and December. Perhaps it would be better to wait until after the distribution to make the investment.
6. Not considering the account type along with the potential taxation of your investments. It makes a big difference, from a tax perspective, whether you are investing in a retirement account or a regular taxable account. Maybe you could hold income investments like bonds or dividend-paying stocks in your IRA to avoid taxes on the income. Perhaps you could structure more growth-oriented investments in your taxable accounts. Or maybe you should use index funds or tax-efficient funds in your taxable accounts, and actively-managed mutual funds in your retirement accounts. All of these are ways of minimizing your tax liability.
As you can see, the tax consequences of your investments can be complex. Your goal is to look at your investments from many different perspectives and it’s important that the tax perspective is one of them. So what should you do with the information we have just gone over? As a starting point, go through each of the investments in your taxable accounts and figure out what your cost basis is for each investment. If you need help, call the brokerage or mutual fund company and ask them to track how much you paid for the investments. This will give you some sense of how much gain or loss you would incur if you sold your investments and how much you would owe in taxes. At the very least, you will have this information organized and ready when you sell your investments and need it to complete your taxes. In the next chapter we will shift our focus to investing for retirement, which is perhaps the most important financial goal most people have.
I’m Greg McGraime and Now You Know!