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.
There are several common tax mistakes associated with IRAs and Roth IRAs, including:
Taking a large distribution out of a retirement account to buy a house can have several negative consequences, including:
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.
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.
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