March 10, 2021
Know investment tax basics.
There are certain things you can’t afford to get wrong as an investor. Making sure you have the right asset allocation and that your risk tolerance aligns with your risk capacity is important. But there’s something else to keep in focus: taxes. Managing tax-efficiency in your portfolio matters if one of your investment goals is maximizing overall return. “An investor’s tax strategy should work together with their investment and income plan,” says Jeff Cutter, president and owner of Cutter Financial Group. That strategy can evolve over time as you move from the accumulating phase of investing to the distribution phase in retirement. With tax season upon us, here are seven of the most important tax mistakes to avoid with your portfolio.
1. Not realizing the full potential of tax-advantaged accounts.
Tax-advantaged plans, such as a 401(k) or health savings account, known as an HSA, can offer tremendous tax savings, if you’re using them to your advantage. Traditional 401(k) plans allow for pretax contributions, which provides a long-term benefit since principal and earnings grow tax-deferred until withdrawn. An HSA can allow you to grow wealth even more strategically. Not only can you make tax-deductible contributions but those contributions, including any matching contributions offered by your employer, grow tax-deferred. Withdrawals for qualified health care expenses are tax-free. Beginning at age 65, you can tap into HSA assets for any reason without a penalty. You’d just pay ordinary income tax on withdrawals, the same as you would a 401(k) or traditional individual Roth account.
2. Investing in the wrong tax-advantaged accounts.
While not maximizing your 401(k) or other tax-advantaged accounts to build your portfolio may be the biggest tax mistake you can make, choosing the wrong accounts to invest in is a close second. Matt Nadeau, a wealth advisor at Piershale Financial Group, says investors should be clear on whether it’s better to pursue a traditional or Roth path when investing in a 401(k) or IRA. Getting that choice right early on can help when planning for long-term portfolio moves, such as converting to a Roth down the line. “Good tax management should be a critical part of investors’ plans because this is one area they can often control,” Nadeau says. “Any time you find tax-saving opportunities, investors can look at this as risk-free returns because they’re able to identify ways to save money on their investments outside the market.”
3. Missing out on opportunities with charitable donations.
Your portfolio could provide an opportunity for tax savings when making donations to charity but only if you’re leveraging the right tools. “A common tax mistake many investors make is giving charitable contributions in cash when they have the option of using appreciated stock to make their donations,” says Christian Patterson, a wealth advisor at Exencial Wealth Advisors. This is when a donor-advised fund, which is essentially an investment account for charitable giving, can help. “Donor-advised funds provide two key tax benefits,” Patterson says. “The ability to avoid capital gains taxes on appreciated stock and the ability to bunch charitable donations.” Using one of these accounts to leverage appreciated stock can help with maxing out charitable donation deductions.
4. Failing to harvest tax losses.
When investing in taxable accounts, it’s important to strike the right balance between gains and losses. David Reyes, a financial advisor and the chief financial architect at Reyes Financial Architecture, says that not harvesting losses against winners is the biggest tax mistake investors often make. Tax-loss harvesting means selling stocks that are in decline and replacing them with similar ones to offset gains. “For active investors, tax-loss harvesting is the best way to reduce taxes in your portfolio,” Reyes says. You just have to watch out for another tax mistake: triggering the wash-sale rule. This IRS rule means you can’t replace a losing stock with a “substantially identical” one within 30 days before or after the sale.
5. Putting your investments in the wrong places.
Where you invest can be just as important as what you invest in when managing tax-efficiency in a portfolio. Another key mistake investors make from a tax perspective is failing to consider asset placement, says Lisa Featherngill, head of legacy and wealth planning at Abbot Downing. “Most investors have various buckets where (the) money is invested,” she says. Your portfolio might include a brokerage account, an IRA, employer-sponsored plan or annuity, each with different tax implications. Putting an already tax-efficient investment like an exchange-traded fund into an IRA might not make much sense. “If an investor starts with a strategic asset allocation, attention should be given to the appropriate placement of the investments,” Featherngill says.
6. Getting tripped up by dividends.
Dividend-paying stocks and mutual funds can generate income for retirement, but it’s important to consider the tax consequences of those investments for future planning. “These investments compel you to pay more tax this year, whether it’s a good year for you to do that or not, because the dividends force income onto your return,” says Ken Robinson, founder of Practical Financial Planning and a certified member of the Alliance of Comprehensive Planners. Robinson says investments that don’t pay much in dividends will grow more in value than the dividend-payers will, all other things being equal. “You, the investor, then get to decide when to take your profit and make it taxable, usually at low, long-term capital gain rates.”
7. Not considering the impact of state taxes.
When planning your tax strategy as an investor, your focus might be on the bigger federal tax picture. But it’s a mistake to overlook how state income taxes can influence your tax situation. “Long-term gains and qualified dividends are taxed at a favorable rate for federal tax purposes, while most states tax this income at ordinary rates,” says Kathy Buchs, director of tax services at MAI Capital Management. “Clients who live in high-tax states, such as California or New York, may pay over 13% just in state tax.” Buchs says investors should be on the lookout for ways to mitigate state tax impacts, such as investing in qualified opportunity zones, which can yield capital gains tax savings.
Be well-versed on these common investing tax mistakes:
This year’s taxes can be complicated. Don’t take a chance and leave it to a tax professional. Don’t have one or want to work with a new one this year? Contact our office at 954-942-1120 and speak with one of our team members. We will be happy to help you. At Louis Mamo & Company we have been providing solutions for businesses and individuals since 1982.
(Sources: CreditCards.com, The Balance and U.S. News & World Report)