[IMGCAP(1)][IMGCAP(2)]Investing is a complex undertaking. The supply of investment alternatives is seemingly endless. Evaluating various alternatives can be quite difficult and very time consuming.
And unless held in check, the actual decision-making process is fraught with human emotions that often lead investors to make counterproductive investment choices. Add to this the myriad tax rules and regulations that impact investments and you have enough to overwhelm many investors.
Trusted financial professionals are in a position to help make sense of it all. Certainly, appropriate portfolios should be structured for investors, and suitable investments should be chosen given the current economic environment and the investor’s unique set of circumstances. But tax consequences must also be carefully considered, and the accountant often plays a role in this. Tax treatment, good or bad, can make or break an investment decision.
Here are the top 10 tax mistakes made by investors as gathered in a recent survey we conducted of investment advisors:
1. Short term vs. long term gains: Realized gains on appreciated securities held for one year or more qualify for favorable tax treatment. Long-term capital gain tax rates are significantly lower than short term rates. Holding a security an extra day, week or month can significantly reduce the tax burden.
2. Foreign stock investments held in a tax-qualified account: Most foreign companies are required to withhold foreign taxes on dividends paid. U.S. investors can claim a tax credit on their tax returns, effectively recouping this lost dividend, but only if the foreign stocks are held in a taxable account.
3. Gold and silver held in a taxable account: Gold and silver are treated as collectibles and therefore are not eligible for capital gains treatment. The federal tax for long-term gains on collectibles is 28 percent.
4. Sale of appreciated securities by elderly investors: The cost basis of appreciated securities is “stepped up” to the current market value upon the death of the owner. Prospective capital gains and related taxes disappear. Conversely, all prospective capital losses will be lost. Elderly investors should consider being quick to sell stocks with losses and slow to sell stocks with gains.
5. Generating excess unrelated business income in a tax-qualified account: Certain investments, such as Master Limited Partnerships, generate unrelated business income. These investments belong in a taxable account. If they are held in an IRA or other qualified plan, and if the Unrelated Business Taxable Income, or UBTI, is greater than $1,000, then the investor must complete and file a rather complex Form 990 and pay additional income tax.
6. Ignoring local tax laws: In some states, investors cannot carry capital losses forward to future years. On a federal return, a capital loss in one year can be used to offset gains in a subsequent year. But capital losses without offsetting gains in a current year are lost for state tax purposes.
7. Failing to consider a Roth IRA conversion: When a traditional IRA is converted to a Roth IRA, tax is due on the converted amount in the year of conversion. If, for whatever reason, an investor will have low income in a year, this is an ideal time to convert and settle the tax bill on this money at a significantly lower rate than is otherwise expected in the future.
8. Failing to realize capital gains: Once again, low income in a given year can provide an opportunity to save taxes. Long-term capital gain tax rates are progressive; rates increase as taxable income increases. For taxable incomes up to $72,500, joint taxpayers pay no tax on long term capital gains.
9. Improperly calculating the cost basis for MLPs: Given their unique tax structure, a large portion of a typical Master Limited Partnership distribution is tax-free. This tax-free distribution is considered a return of principal and should therefore serve to reduce the cost basis. In this case, ignorance may be bliss because the reduction in basis would result in a higher capital gain at sale (unless the IRS comes knocking…).
10. Allowing a pension plan to become non-compliant: While not as common as the others, this mistake can be very costly. There are a number of actions or inactions that can put a plan’s qualified status in jeopardy. Oftentimes, an investor will establish a plan with a brokerage firm, and then assume that the brokerage firm is taking care of the ongoing regulatory requirements, including the filing of IRS Form 5500. Brokerage firms rarely do this even though they may have provided the original plan document template. Failure to meet ongoing regulatory requirements can result in disqualification of the plan and a very large tax bill. Investors should consider hiring a third-party administrator to take care of their ongoing compliance obligations.
An effective, long-term investment process must consider and evaluate the overall economic environment, individual investments, tax laws and human emotions. This process is ongoing. Only by constantly balancing all of these elements can after-tax returns be maximized.
John Burke, CFP, is president of Burke Financial Strategies and is a financial advisor with Raymond James. He has been advising clients and managing assets for 30 years. Steven Criscuolo, CPA is chief financial officer of Burke Financial Strategies and is a financial advisor with Raymond James. Before joining Burke Financial Strategies, he spent 20 years as CFO and president of three highly successful, midsize privately held businesses, where he also provided investment advisory and estate planning services.