7 Common Investment-Related Tax Mistakes

Taxes are usually a bigger drag on returns than expenses, though they are less visible and get less attention.  How many of these 7 common mistakes are you making?

Before you sell a security, check the purchase date.  If you bought it less than a year ago, any gain in that security will be a short-term gain.  Short-term gains are subject to tax at ordinary income rates (which go as high as 37%).  If you wait to sell it until you have held it at least a year, it will be taxed at a lower long-term capital gain rate, typically 0% or 15% (or if your income is extremely high, 20%).   If you believe that you must sell for investment reasons, try to realize a loss to offset the gain, since it is net capital gains that are taxed.

Even if you are tax-aware enough to avoid realizing net short-term gains, what about your fund managers and advisors?   Investment professionals know that almost no investors evaluate them on an after-tax basis, so they tend to ignore the tax implications of their activities.  The biggest issue is turnover and the resulting realization of short-term gains.  Actively managed funds are particularly likely to hit investors with large tax bills because of their turnover and the consequent realization of gains.   

ETFs are extremely tax-efficient vehicles for two reasons.  First, they are usually passively managed (to an index), which helps to reduce their turnover.  Second, they are able to intentionally distribute out low tax basis shares to the “authorized participants” (sort of like market makers) with which they trade when large outflows occur.  This second advantage means that compared to mutual funds, ETFs are a more tax-efficient form of organization. Even when they are both passively managed to the same underlying index, an index ETF will be more tax efficient than an index mutual fund, especially if significant outflows force the index mutual fund to sell highly appreciated positions.  ETFs rarely make any distributions of capital gains.  Ever. 

If like most people you have both tax-deferred investment accounts, like IRAs and 401(k)s, and taxable investment accounts, you want to make sure that your least tax-efficient investments are sheltered from current taxation by being inside of a tax-deferred wrapper, such as an IRA or 401(k).  These would include any investments with a high turnover, such as actively managed funds, or those that throw off a lot of taxable income, such as corporate, convertible, or preferred bonds, especially high-yield bonds.  Tax-efficient investments, like index funds or individual stocks, are ideal for your taxable account.  You will only have to pay taxes on dividends, most of which will be “qualified” for the special rate of 0% or 15% (or if your income is extremely high, 20%).  Investments that are likely to build up a significant capital gain are best held in a taxable account in order to take advantage of the lower tax rate on long-term capital gains, which is typically 0% or 15% (or if your income is extremely high, 20%).  Remember, those gains will be taxed as ordinary income (at rates as high at 37%) when held in a traditional IRA or 401(k) and then distributed out as taxable income. 

No one likes to lose money on an investment but realizing a loss (by selling) can lower your tax bill.  You can use losses to offset gains, and up to $3000 can be used to offset ordinary income.  You can buy the same security back again after 31 days (avoiding the “wash sale” rule which would otherwise disallow the realization of the loss).  If the security is an index fund (such as an index ETF), you don’t have to wait 31 days:  you can immediately switch into another similar fund as long as the underlying index is a different one.   

Health Spending Accounts (HSAs) provide a “triple” tax benefit:  1) contributions are tax deductible, 2) the build-up is tax-free, and 3) qualifying medical distributions are tax free.  This makes the HSA a combination of the best elements of the traditional and the Roth IRA, in a way.  For that reason, for those who qualify, contributing to an HSA should come before even contributing to an IRA. To qualify you must have a High Deductible Health Plan (HDHP), which in 2019 means a minimum deductible of $1,350 for an individual or $2,700 for a family.  For 2019, maximum contributions are capped at $3,500 per individual and $7,000 per family.

Some people confuse HSAs with healthcare flexible spending arrangements (FSAs, or flexible spending accounts) where you used to lose the money you set aside in pretax salary deferrals if you didn’t spend it in the plan year.  However, all the money you put into an HSA is always yours to keep, even if you leave your employer.  A smart way to maximize the benefits of an HSA is to think of it as a “medical IRA.” Don’t spend anything out of it until you absolutely have to—let that tax-free buildup work in your favor.  Instead of paying for current medical expenses, keep the receipts.  You can reimburse yourself out of your HSA even many years later if you have receipts to prove your medical expenditures.

Most of us seek immediate gratification, or at least short-term gratification instead of long-term gratification.  Maybe this helps explain why traditional IRAs and 401(k)s are much more popular than their Roth counterparts.  Contributing to a traditional IRA or 401(k) lowers your current taxable income and your current taxes, whereas contributing to a Roth does not.  On the other hand, distributions from a traditional IRA or 401(k) will ultimately be taxed (at ordinary income tax rates), whereas Roth distributions are not taxed at all.  The Roth is delayed gratification.

The usual assumption regarding the traditional IRA and 401(k) is that your income and tax rate will go down once you retire and stop drawing a paycheck.  However, those with considerable balances in their retirement accounts may find that their income goes up, not down, after they retire, especially after they reach 70½ and start having to take required minimum distributions (RMDs) from their retirement accounts. 

They key consideration is whether the investor’s current marginal tax rate (the rate on the last dollar of income) is higher or lower than what it will be in retirement.  If it is higher now, then it makes sense to maximize the current deduction and use traditional retirement accounts.  If it will be higher in retirement, it probably makes sense to use Roth retirement accounts.

One example of the types of people who should consider a Roth are those who are early in their careers.  They are usually not making as high an income as they will later, so their current tax rates are low. 

Another group that should consider a Roth is early-stage retirees.   Their income may be comparatively low because they are not drawing a paycheck, especially if they are not yet receiving Social Security or having to make required minimum distributions from their IRAs.  Even if they can't contribute to a Roth IRA because they are not earning income, they should consider a “Roth conversion.”  This involves moving some money from a traditional IRA into a Roth IRA.  When you convert, the amount converted becomes taxable income, but this makes sense if the tax rate is lower now than it will be later. 

In the past, to be able to convert from a Traditional to a Roth IRA your income needed to be under $100,000. The IRS rules have changed and there is no longer an income cap in place.  With the cap removed, high-income earners can now convert as long as they pay the appropriate tax on the conversion. There is no 10% early withdrawal penalty if the funds move from a Traditional IRA to a Roth IRA in a 60-day window.   Funds can start to be withdrawn from the Roth after 5 years.

Sometimes there are other reasons for a drop in income, even during your working years.  These episodes also provide possible opportunities to either make contributions to a Roth IRA (income limits apply) or do some amount of Roth conversion in order to take advantage of a temporarily low tax bracket year, or both.

The government can change the rules at any time, and they regularly do.  We recently had a sizeable reduction in tax rates as a result of Tax Cuts and Jobs Act of 2017 (TCJA).  The rhetoric of progressive Democrats indicates that they would like to raise tax rates aggressively, especially on upper income earners.  As if it is not difficult enough trying to guess what your retirement income will be, another twist is trying to guess what future politicians are likely to do to future tax rates. 

One way to try to manage all of this uncertainty is to hedge your bets by having a balance of both traditional and Roth retirement money. That way, you can better manage your taxable income each year by selectively distributing from one type of account or the other (as long as you still distribute at least the minimum required from your traditional IRA).