Tax Investment Mistakes: Real Examples We've Seen

Written by Canty Financial - Published on March 22, 2023

It’s important to understand the tax implications of investment decisions because taxes can have a significant impact on your investment returns. Here are some real-life examples we’ve seen of tax investment mistakes.

Misuse of IRAs and Roth IRAs

There are several common tax mistakes associated with IRAs and Roth IRAs, including:

  • Early withdrawal penalties: If you withdraw money from your IRA before age 59 1/2, you may be subject to a 10% early withdrawal penalty in addition to income taxes on the amount withdrawn.
  • Timing of withdrawals: Distributing funds from retirement accounts involves substantial tax planning. If your income is higher than usual in a particular year, resulting in a higher tax bracket, it would be advantageous to take distributions from your Roth IRA. Conversely, if your income drops, placing you in a lower tax bracket than usual, it would be more advantageous to withdraw funds from your traditional IRA that year. This strategy will allow you to pay less tax or possibly no tax on your IRA distribution depending on your tax situation.
  • Failure to use tax-advantaged accounts: A tax-advantaged account, such as an Individual Retirement Account (IRA) or a 401(k) plan, provides tax benefits that can help reduce your tax bill. Here are a few examples:
    • Tax-deferred growth: With a traditional IRA or 401(k), you can contribute pre-tax dollars, which means you don't pay taxes on that money until you withdraw it in retirement. This can help reduce your taxable income each year you make contributions.
    • Tax-free growth: With a Roth IRA or Roth 401(k), you contribute after-tax dollars, but your investments grow tax-free and you won't owe any taxes on qualified withdrawals in retirement.
  • Failing to Convert Traditional IRA to Roth IRA Correctly: Taxpayers who convert a traditional IRA to a Roth IRA must pay taxes on the converted amount. If the conversion is not done correctly, it may result in additional taxes and penalties.
  • Failing to Name a Beneficiary: Not naming a beneficiary for an IRA can result in delays in distribution, less favorable tax treatment, lost opportunities for tax benefits, and loss of control over the distribution of assets.
  • Failing to Take Required Minimum Distributions (RMDs): Traditional IRAs require owners to take RMDs starting at age 73. Failure to take the RMDs can result in a 50% penalty on the amount not distributed. Roth IRAs do not require RMDs during the account owner's lifetime, but they do require them after the owner's death.

Taking Large Distributions out of Retirement Accounts to Purchase Real Estate

Taking a large distribution out of a retirement account to buy a house can have several negative consequences, including:

  1. Taxes and Penalties: Withdrawing a substantial amount of money to buy real estate can push you into a higher tax bracket. This can considerably decrease the amount of money you receive from the withdrawal. Additionally, if you take out money from a traditional IRA or 401(k) before you reach the age of 59½, you may incur a 10% early withdrawal penalty on top of taxes due on the distributed amount.
  2. Impact on Growth of Retirement Savings: Taking a large distribution out of a retirement account will significantly reduce your retirement savings. Even if you plan to repay the money later, you may miss out on potential investment growth, which can impact your long-term financial security. Instead of taking a large distribution to purchase real estate, you can make a down payment and allow your investment returns to pay off the real estate purchase over time.

Understand Your Cost Basis Before You Sell

Understanding your cost basis is essential before selling an investment. The cost basis is the original purchase price of an asset. When you sell an asset, you will owe taxes on any gain above the cost basis. If you sell an asset for less than the cost basis, you may be able to claim a loss for tax purposes.

If you sell an asset after holding it for less than a year, any gains will be considered short-term capital gains and will be taxed at your ordinary income tax rate. However, if you hold the asset for more than a year before selling it, any gains will be considered long-term capital gains, which are taxed at a lower rate.

For this reason, understanding your cost basis is crucial to accurately calculate your tax liability and avoid overpaying or underpaying taxes. If you do not know your cost basis, you may end up paying more in taxes than you owe or risk facing penalties for underreporting your income.

Not Taking Full Advantage of Stepped-Up Basis

As an elderly person, it can be better to not realize gains on investments and instead hold onto them to get a stepped-up basis because it can potentially reduce the capital gains tax liability for you and your heirs.

When an individual dies, their heirs generally receive a "stepped-up basis" for inherited assets, including investments. This means that the basis of the asset is "stepped up" to the fair market value on the date of the individual's death, regardless of the original purchase price. For example, if an individual purchased a stock for $10 and it is worth $50 at the time of their death, their heirs would inherit the stock with a basis of $50.

If the heirs were to sell the inherited asset, they would only owe capital gains tax on any increase in value that occurs after the date of the individual's death. This can potentially reduce or even eliminate the capital gains tax liability. However, this strategy should be considered in the context of the individual's overall financial situation and goals, as there may be other factors that weigh against holding onto investments for an extended period.

Capital Gains Distributions Can Erode Returns

Frequent large capital gains distributions out of mutual funds can erode investment returns over time. Mutual funds can issue capital gain distributions to the fund’s shareholders at any time. These distributions are taxable, even though the shareholder did not sell any portion of the mutual fund. Depending on the size of the distribution and the shareholder's tax bracket, the tax liability can be significant, reducing the overall investment return.

On the other hand, ETFs (Exchange Traded Funds), offer more control over taxable events. Most ETFs do not have capital gain distributions, so taxpayers are less likely to be hit with a large tax surprise at the end of the year. Shareholders of ETFs realize gains when they sell, so they have much more control over when they would like to realize a gain. At Canty Financial we build our portfolios primarily using ETFs with the goal to maximize our client’s after-tax returns. 

Overall, it's important for investors to be aware of the potential impact of capital gains distributions on their investment returns over time. If investors are forced to sell investments to pay a large tax bill on a capital gain distribution each year, then it's highly likely to have a negative impact on long-term returns. 

If you have any questions about the tax implications of your investments, please feel free to reach out, we are here to help. 

Bill Canty, CFP®, CPA

Ed Canty, CFP®, Investment Advisor

Joe Canty, Investment Advisor

Maureen Walsh, EA, Tax Advisor

Tina Alteri, CPA, Tax Advisor

Subscribe to Our Monthly Newsletter!

preparing for retirement guide
Stay Up to Date on the Latest Financial Planning News.

Latest Posts

Subscribe to Our Monthly Newsletter!

Stay Up to Date on the Latest Financial Planning News.
Canty Financial Management
20 Church Avenue 
Ballston Spa, NY, 12020

5129 Castello Drive Suite #1
Naples, FL, 34103
Michael Canty Memorial Fund
Legal, privacy, copyright and trademark information.

Ready to create your financial roadmap?

Want to see if our services are right for you?
Schedule a complimentary, 15-minute phone call today.
Schedule a Call
Copyright © 1987 – 2024 Canty Financial Management Inc. All Rights Reserved.
Website managed by Stallion Cognitive
heartchevron-down linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram