Avoid the Top 10 Investment Tax Blunders

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We realize that a review of your year-end tax situation may not be at the top of your holiday "to-do" list but think of it this way: devoting a few minutes now could save you big bucks at tax-time. Who knows? Maybe the thought of all the money you’ll save will even add to your holiday cheer.

We surveyed accountants and money managers around the country to find out what year-end blunders commonly surprise, irk and cost investors at tax-time. The good news: by following these tips, you can reduce your taxes in April and even increase the after-tax return on some of your investments.

1. Expect distributions from funds that declined in value.

Mutual funds must distribute capital gains to shareholders. So you may receive a taxable distribution even if the share price of your fund has declined this year. Be prepared and set aside cash so you won’t be forced to scramble to pay taxes in April.

2. Don’t invest in a mutual fund shortly before a capital gains distribution.

If you buy a mutual fund shortly before a capital gains distribution, part of your investment will almost immediately be handed back to you. The result: you’ll owe tax on the distribution and have less money to reinvest.

Tip: Ask the fund company the date of the next scheduled distribution and purchase shares after this date.

3. Manage "tax-exempt" investments wisely.

"People don’t realize that a lot of the total return on tax-exempt funds is caused by the manager buying and selling within the portfolio," says Maria Scott, editor of the AAII Journal. "That can be annoying for people who don’t expect to pay taxes on tax-exempt investments." While interest payments from muni bond funds may be tax-exempt, capital gain distributions are not.

The same applies to gains on the sale of municipal bonds and municipal bond fund shares. Any gains you realize are taxable.

4. Consider the timing of fund transfers.

You may think that selling one bond fund to buy another is just a way of rebalancing your portfolio, but the IRS will view the sale as a capital gains transaction. "It’s such a simple mistake but it happens to people all the time," says Frank Degan, a certified financial planner in Long Island, New York.

You can postpone the tax by transferring between funds after Dec. 31st, but if you’re committed to making the transfer this year, be sure to withhold part of the sale proceeds to pay taxes on the gain. The capital gains estimator on TurboTax.com can help you determine how much you’ll owe.

5. Max out your retirement plan contributions.

Contributing the maximum to tax-sheltered retirement plans will help maintain your lifestyle years from now and it can also help in the near-term by reducing this year’s taxable income.

The 401(k) calculator on TurboTax.com can show you how much you’ll save by maxing out contributions. If you’re interested in tax-deductible IRA contributions, the IRA planner will determine your eligibility.

6. Steer clear of tax-free investments in tax-sheltered plans.

In a tax-sheltered plan, interest, dividends and capital gains grow tax-free anyway so you’ll do better concentrating on high-yielding income and growth-oriented investments rather than annuities or municipal bonds.

7. Don’t hold on to dogs.

Nobody likes admitting mistakes but the fact is that selling a loser in a taxable account can save you money and free up cash for more promising investments. The reason: the IRS allows investors to offset realized gains with realized losses. You can also use up to $3,000 in additional losses to reduce your taxable income. Let’s look at some numbers:

Say you were savvy enough to buy Microsoft in the mid-90’s and this year, you’ve cashed in some of your shares for $10,000 in gains. Based on this sale and a 15% capital gains tax rate, you'll owe $1,500 in taxes.

Unfortunately, you weren’t savvy enough to avoid the dot-com rout and you’ve also seen some shares decline in value by about $13,000. If you sell your dot-com dogs and take $13,000 in losses, you can offset your $10,000 Microsoft gain with $10,000 in realized losses. So you’ll no longer owe $1,500 in capital gains taxes. You can also use the remaining $3,000 loss to reduce your taxable income.

If you’re convinced your dogs will turn into dream stocks, you should of course not sell for tax reasons alone. But remember that a stock that has dropped 50% in price needs to gain 100% just to break even.

8. Know the limit on losses.

Before you cash in all your dogs, we have one caveat: losses are limited to offsetting realized gains and up to $3,000 in ordinary income. Any losses above this amount can be carried over for use in future years but you should know they wouldn’t benefit you this year.

9. Avoid wash sales.

If you’d like to offset gains with losses, be sure to avoid "wash sales." A wash sale occurs when you sell a security at a loss and repurchase the same security within 30 days (before or after) the date you sold. The IRS forbids using these types of losses to offset gains.

"A lot of people near retirement have set up periodic withdrawals from mutual funds," says David Greene, an accountant in Madison, Wisconsin. "But if they are also automatically reinvesting dividends at the same time in a bear market, they can accidentally trigger wash sale losses."

That said, there are a few tricks you can use to realize losses and keep your portfolio in balance. You can sell and buy back a security 31 days after the sale. Or if you can’t wait 31 days, you can buy a security that is similar but not identical to the one you sold. You can replace a large-cap growth fund with a different large-cap growth fund, for instance, or a stock in one computer company with a stock in another computer company. For more information on wash sales, see FAQ on Wash Sales.

10. Don’t underestimate your cost basis when you sell.

When calculating cost basis, most people remember to factor in commissions on trades or mutual fund transaction fees. But experts say many overlook money that has automatically been reinvested. "A lot of people forget that over time, reinvested capital gains and dividends can add quite a bit to cost basis so their gains are really much smaller than they believe," says financial planner Doyle. "They can end up overpaying on taxes for no good reason."

When it comes time to sell, be sure to review all of your purchases (even that small purchase of 1.4563 shares bought with $13 in dividends). You’ll wind up with a smaller taxable gain and a better idea of your actual return on a fund