Investing is a key way many Americans grow their wealth. Unfortunately, taxes are a normal part of investing. If not managed wisely, certain actions can unintentionally raise your tax bill.
Avoid these four investing decisions if you want to avoid a surprise during tax season.
1. Ignoring Where You Hold Your Investments
An IRA is a powerful retirement planning tool. Contributions are tax-deductible in the year it occurs in the case of a traditional IRA, or you can opt for a Roth IRA that typically allows for tax-free withdrawals if they’re qualified.
Another key benefit of IRA accounts is that they’re tax sheltered. Gains on trading, dividends or distributions received aren’t taxable if held inside an IRA. If you hold them in a taxable account, you may incur taxes for such activity. Even if you’re a passive investor, you may face taxable liability if you overlook using an IRA.
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2. Frequent Rebalancing in Taxable Accounts
Investments increase and decrease over time. Left unchecked, your portfolio may not be on track with your strategy. If your portfolio isn’t aligned with your plans, selling a holding may be necessary.
Done in a retirement account doesn’t create a taxable consequence, but that’s not the case in a taxable account, per Fidelity. Selling an investment at a gain may create a nasty tax bill.
If you held the investment for less than a year, it may result in a short-term capital gain, which is commonly taxed as ordinary income. Gains on investments held for more than a year are generally taxed at lower rates. Even minor trades to maintain your strategy can trigger gains. Experts typically recommend rebalancing every six to 12 months, especially if done in a taxable account.
3. Making Tax-Loss Harvesting Mistakes
Tax-loss harvesting can be a meaningful way to manage taxable responsibilities. Seemingly difficult, the idea is simple in theory. Tax-loss harvesting lets investors sell an investment at a loss to offset gains on other investments.
The result is that you pay taxes on your net gains, and you can use up to $3,000 in net losses to offset ordinary income, according to Vanguard. A simple mistake can betray this goal. If you purchase the same or substantially identical investment 30 days before or after the day of the sale, the loss is disallowed. Speaking with a tax or financial advisor can help avoid such mistakes.
4. Neglecting Tax-Efficient Funds
Mutual funds are an attractive investment option for Americans. However, even if you don’t sell shares of a fund, you may incur a liability in a taxable brokerage account.
Actively managed mutual funds with frequent trades may create capital gains distributions to investors, even if you didn’t personally sell shares. If you prefer mutual funds and use a taxable account, focusing on funds with lower turnover is wise, per T. Rowe Price.
Ignoring tax-sheltered accounts and frequent selling can quietly increase your taxable liabilities. Small tweaks can reduce tax surprises without impacting your investing goals.
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This article originally appeared on GOBankingRates.com: 4 Common Investing Mistakes Can Quietly Raise Your Tax Bill
