Taxes are an emotional issue. Sometimes, people's focus on avoiding them can distract them from what is in their best interests. Here are five mistakes you should avoid when managing the taxes on your investments.
1. Overlooking taxable retirement distributionsQualified retirement plans have certain tax advantages. Money going into a traditional IRA or a 401(k) can be deducted from your income, and earnings on your investments within these plans is tax exempt as well. There is a catch, though: The distributions you ultimately take out of these plans is taxed as income at that point. This has a couple implications. First, when you are doing your retirement planning and figuring out how much income you'll need, be sure to account for the fact that money coming out of a retirement plan will be taxed. Second, depending on your tax bracket, there may be a disadvantage to having growth investments in your IRA, since any gains will ultimately be taxed as income, and not at the capital gains rate.
2. Trying too hard to avoid capital gains taxesSpeaking of capital gains, people are sometimes reluctant to sell stocks when they are up because realizing the gain will make it subject to taxation. However, it's important not to let the tail wag the dog. Paying a 15 percent tax on a 50 percent gain will actually cost you only 5 percent of the total value of the investment. You could lose much more than 5 percent if the investment goes south on you while you are putting off selling.
3. Harvesting capital losses carelesslySome investors like to "harvest" losses near the end of the year to offset gains. When you do this, keep in mind the potential opportunity cost. Harvesting a 20 percent loss would have a tax benefit equivalent to less than 4 percent of the investment's current value, so you shouldn't sell if you think that stock might bounce back by 4 percent or more during the 30-day waiting period before you would be permitted to repurchase the stock.
4. Gambling on off-shore accountsCypress is an example of an off-shore haven that was popular with people trying to shelter money from their own governments. But when the banking system in Cypress was in crisis, many of those foreign accounts were assessed huge levies to bail out the banks. Those investors probably wish they had just paid their taxes in the first place. Tax evasion is not only cheating, but if it involves moving money out of the country, it also entails giving up the protections of U.S. law and FDIC insurance.
5. Forgetting Treasury securitiesConsidering how some people go overboard to avoid taxes, the tax benefit of owning U.S. Treasury securities is surprisingly overlooked. Income on these securities is subject to federal taxes, but exempt from state and local income taxes. This might be especially relevant now because Treasury yields have been rising while CD rates have not. So a five-year Treasury might be an attractive income alternative to a five-year CD, with the added benefit of a break on state and local taxes.
The bottom line is that tax considerations should not be blown out of proportion. They should be quantified, and then judged in connection with the risk and return potential of each financial decision you make.