15 Investment Pitfalls and Surprises to Avoid During Tax Season
1. Failing to understand long-term versus short-term gains
Not all investment gains are treated equally come tax time. Long-term investments are those held for a year or more, and short-term gains are anything shorter than a year. People who hold stocks, mutual funds, or ETFs for less than one year have to pay taxes on any gains based on their current federal income bracket. Capital gains on long-term investments are generally taxed at lower rates.
For example, here are the tax rates for married people filing jointly as of 2018: Those making less than $77,200 will pay a long-term capital gains rate of 0%; those with ordinary income of $77,201 to $479,000 will pay 15%; and those earning $479,001 and higher will pay 20%. Depending on the purchase date, sometimes delaying sale of an investment by a few days or weeks can make a huge difference in the taxes owed.
2. Early withdrawal penalties in 401(K) and IRAs
Most investors and savers know that if they withdraw funds from a 401(K) or IRA account before they are eligible, they will have to pay taxes on those funds. What is often overlooked is the 10% penalty the IRS levies on early withdrawals — on top of any income taxes paid on those withdrawn funds.
3. Harvesting losses and running into the Wash-Sale Rule
One strategy investors use to lower taxes is called loss harvesting, whereby they lock in a loss on an investment to offset capital gains and potentially even income if the losses outweigh the gains. Those using the strategy, however, need to be aware of The Wash-Sale Rule. This regulation is aimed at keeping people from lowering their taxes artificially by selling or trading a security at a loss only to buy it again within 30 days. Some investors also may not be aware the rule applies even to a stock, ETF, or fund that is deemed to be “substantially identical.”
4. Thinking municipal bonds are entirely tax-free
Investors flock to municipal bonds for tax-free income as interest paid on municipal bond is generally exempt from federal taxes and sometimes state and local taxes as well. It is a huge market, valued at roughly $3.8 trillion. When investors turn to muni bonds, however, they may overlook, or inadvertently create, another taxable situation.
Having too much tax-free income can trigger the Alternative Minimum Tax (AMT), and realizing any profits from a bond can also trigger a capital gains tax. Also, municipal bonds’ tax-free status only applies to muni bond issues from the investor’s state of residence (hence all of the single-state muni funds under the Nuveen name). To complicate matters further, some municipal entities issue bonds that are actually not exempt from taxes.
5. Failure to qualify for IRA and 401(K) Plan Deduction
Most investors just assume that they can contribute up to the maximum allowance in retirement plans and then deduct those contributions. This mistake tends to be made by high-income taxpayers as there are income limits on some of these accounts, such as a Roth IRA, where contribution limits decline with income.
Another problem that tends to affect higher earners are so-called “top-heavy” 401(K) plans where the employer contributes more to key employees than all other employees.