Monday, February 23, 2015

Investors, Don't Make These Tax Blunders / Mistimed sales, Roth-conversion mistakes, and failing to plan for unforeseen events top readers' lists.

Adam Zoll for Morningstar.com writes: It's often said that one shouldn't let the tax tail wag the investment dog, which is just a cute way of saying that tax considerations should not dominate one's investment decision-making process. However, that doesn't mean one should ignore taxes altogether, as tax-smart investing can pad investors' aftertax returns while tax-ignorant investing can erode them. 

Morningstar.com readers on our Personal Finance discussion board were asked last week to recall some of their worst investment-related tax mistakes and came up with quite a list. Some were classic beginner missteps--such as selling shares at the wrong time and, thus, triggering a larger-than-anticipated tax bill--while others involved unforeseen life changes. Fortunately, we can all learn from the mistakes fellow readers have shared and try to avoid them ourselves. 

You can read the full discussion here, including the excerpts that follow. And stay tuned to Morningstar.com in the days to come as we present our annual Tax Relief Week special report.

Tax Tumult Takes Many Forms
The sheer variety of tax blunders readers said they'd made was somewhat surprising in itself.
"I keep forgetting that selling stock, even out of a mutual fund, is considered income," wrote Sergeantmajor. "I've got to check this next time, and perhaps find needed capital elsewhere. I am now keeping back a larger portion of cash in my portfolio for unexpected needs."
Reader retiredtaxmgr also shared a tax lesson he or she learned the hard way: "I had kept investing in a balanced fund inside a taxable account. I ended up paying income taxes for the high amount of dividends and capital gain distributions. I should have invested the fund inside a tax-deferred account to defer taxes. Or, instead of investing in a balanced fund, I could have put some in a bond fund inside a tax-deferred account and the rest in an equity fund inside a taxable account."
For patleon2, frequent trading led to an unwelcome tax surprise.

"A few years after I retired I subscribed to a service that recommended profitable trades without the hassle of my having to sift through a lot of research," the commenter wrote. "And profitable it was. Short-term gains resulted in a huge tax bill that year. I unsubscribed soon after that!"

Another tax problem that can trip up investors involves the alternative minimum tax, in which investment income can reduce the taxpayer's exemption and, thus, lead to a higher overall tax bill (for a fuller explanation, see "Is the AMT Costing Me More in Capital Gains Taxes?").

Just ask Uysses.

"One big personal mistake was selling a large block of very appreciated employer stock and paying more taxes than planned due to the capital gain being affected by the alternative minimum tax, which I didn't realize was the case," the commenter wrote.
Margaret17 said the problem was her decision to let an advisor make trades for her that led to "enormous capital gains when the tech bubble hit. I blame myself because I knew I needed to sell but lacked confidence in myself. My financial education started right after that. No matter what the blunder or how painful it was, if we can learn something from it, then there is something worthwhile about it."

Others cited errors in the timing of an investment sale. In the case of meddguy, it was being overly tax-conscious that proved costly.

"I bought this stock and held it for about 11 months," he said. "I had about an 80% profit. So, I decided to sell but just wait one more month so it would be long-term capital gains. As I am sure you guessed, the stock took a dive, and by the end of the month I barely had a 15% gain."
Then, there are those times when doing what seems to be the right thing turns out wrong, as in the case of Linehan, who wrote, "My wife was pressuring me to pay off our mortgage so I took the money out of my 401(k) to do it. The taxes on the withdrawal and loss of [the mortgage interest] tax write-off wiped out any savings of paying off the loan."

Bond-Related Blunders
Even with the variety of tax woes shared by readers, a few common themes were evident. One was the danger of holding bonds in a taxable account.

"I bought EE- and I-bonds and just left them sit," recalled valou. "Now that they are about to mature I really have a tax problem. Those $500 bonds are worth over $1,500. I've made other blunders, but those bonds are on my mind right now."

Reader chart tried to use tax-free municipal bonds to reduce his or her tax bill, but things didn't turn out as planned. 

"I sold taxable-bond funds and stock funds in 2012 to create a muni-bond account of single-state bonds to generate tax-exempt earnings instead of taxable earnings," chart wrote. "I did not realize how much taxable capital gains were involved in the sales. As a result, I pushed our taxable income so high that year that my wife and I each got hit with the Medicare surcharge. ... That cost us $1,008 [in] additional Medicare premiums in 2013. Additionally, the gains pushed us into a higher tax bracket in 2012. Plus, the higher income made us ineligible for the state income deduction for seniors on our 2012 state tax return. A better approach would have been to split the mutual fund sales into two tax years."

Conversion Chaos
But perhaps the most common tax error cited by readers involved converting assets from a Traditional IRA to a Roth IRA.

For example, ShakAttack said that in his or her case, waiting to do so was a mistake. "Instead of doing it all at once as soon as it became permissible, I did it a bit at a time hoping for a [market] correction to reduce the cost. Unfortunately, markets rallied, and I ended up paying a lot more in taxes than I needed to," ShakAttack said.
For dorkmeyer, a recent Roth IRA conversation has turned into a tax disaster because of some unforeseen investment income. 

"I converted Traditional IRA money to a Roth IRA in an amount that I expected would keep my total taxable income within the 15% tax bracket on the assumption that the amount of the year-end annual capital gains distribution for one of my mutual funds would be approximately the same in 2014 as it had been in each of the preceding two years," dorkmeyer said. "Proving that what they say about the word 'assume' is true, the 1099 that I received from that mutual fund a couple of weeks ago stunned me with the info that the fund's capital gains distribution for 2014 was nearly four times as much as it had been in each of the two preceding years, rocketing my total taxable income well into the 25% tax bracket. For this fool and his money, the expensive lesson learned is that, in future such situations, I should call the mutual fund near year's end to get some idea of what its annual capital gains distribution is likely to be." 

Then, there was Hyrground, who missed an opportunity to convert assets to a Roth altogether. 

"After reading several sources which indicated contributions to Roth IRAs were permitted until the tax deadline in the following year (e.g. April 15, 2014, for contribution year 2013), I held off doing a sizable conversion to a Roth until after Jan. 1. Unfortunately, I learned too late that that rule only applies to new contributions, not conversions--so I missed the window for that contribution year and could not do the conversion at all," the commenter said.
(For a broader discussion of Roth and other IRA mistakes, read "20 IRA Mistakes to Avoid" by Christine Benz, Morningstar's director of personal finance.)

When the Unexpected Happens
Another common theme among readers' tax mistakes was the high price of unforeseen circumstances. 

Tomas47 recalled that, "In the early 1980s, I bought several real estate master limited partnerships. Worked great until the Tax Act of 1986 changed all the rules. Income tax filing was a nightmare requiring several additional forms and waiting until the last minute for K-1s to show up. [It was] so bad I told my wife to refuse to inherit them if I died--just walk away. I eventually was able to sell them on the third-party market. Out-of-pocket cost to transfer was more than the sale price I received. Given the tax advantages of the early years, my total losses were an inexpensive education that added a couple of rules to my investing process: 1) If you don't understand it, don't buy it. 2) If it adds a new form to your tax return, proceed with extreme caution."

One reader, DCFTim, shared the story of how his mother's death led to unexpected tax problems. 

He wrote, "My mother died suddenly last year from complications related to Alzheimer's. I was managing her affairs when she was alive. Early in the year, several price targets were hit, which triggered the sale of certain holdings. I was expecting that her medical expenses would greatly reduce her taxable income, and I was planning to do further tax mitigation within the portfolio as necessary. Because of her mid-year death, though, things did not go according to that plan."

A couple of commenters mentioned that they thought they'd pursued smart federal income tax approaches with their portfolios but had failed to consider one thing: state income tax.
"The worst blunder was not learning about California tax rules until I'd lived there for 10 years," wrote artsdoc. "Everyone spends so much time learning about federal tax rules, but when you're living in a high-tax state, it's worth the time to learn about state tax rules."

FingerlakesGuy told a similar tale, but with a twist.
"My worst investment-related tax blunder? Selling highly appreciated funds in a year that my income was down to avoid federal taxes," he said. "Mission accomplished. Unfortunately I forgot to consider state taxes, so I took a sizable state tax hit. Luckily all was not lost. I repurchased the same funds at a lower cost basis, so in actuality I didn't really lose anything in the long run. It was just a surprise I wasn't expecting, but in the end, the taxes should end up the same or lower."

Given the results of some other readers' tax stories, that qualifies as a happy ending.

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