Raise your hand if you want to pay extra taxes. Yup, that's what I thought -- even the IRS says that you shouldn't pay more taxes than you must. Yet taxpayers make expensive mistakes year after year and end up overpaying both their income taxes and their investing taxes. Once you've read through this list, you'll be equipped to do better than the average taxpayer at keeping your taxes to a minimum.
1. Not considering itemized deductions
When you prepare your federal tax return, you have the choice of either claiming the standard deduction or adding up all the "itemized" deductions you qualify to take and claiming those instead. To get an idea of what qualifies as an itemized deduction, pull up a blank copy of Schedule A. This IRS form is essentially an itemized deduction cheat sheet: it's a list of the largest and most common of these deductions. Run through this list and note any deductions you could claim, then do a rough estimate of how much the total would be. If it's higher than your standard deduction, go for it.
This may be the last year that itemized deductions are a good choice for most taxpayers, so take advantage of them while you can. Itemizing won't be the best option for everyone, but if you don't at least add up the numbers and make the comparison, you could be giving a lot of extra money to the IRS.
2. Selling investments too early
Capital gains are the profit you make from selling investments such as stocks and bonds. These gains come in two flavors: short-term and long-term. Short-term capital gains are what you get from selling an investment after owning it for one year or less; long-term capital gains are the profits from investments you've held for more than a year.
This is an important distinction because short-term capital gains are taxed at a different rate from long-term capital gains. Long-term capital gains get a discounted tax rate that's always lower than the rate at your highest income tax bracket. If your top tax bracket is anywhere between 25% and 35%, your long-term capital gains tax rate is 15%. If your top tax bracket is below 25%, your long-term capital gains tax rate is 0%.
Short-term capital gains, on the other hand, are taxed at the same rate as your highest income tax bracket. In other words, someone in the 25% tax bracket would be charged a 15% tax on their long-term capital gains and a 25% tax on their short-term capital gains. So if you had $500 worth of gains by the end of the year, you'd pay $75 if they were long-term gains and $125 if they were short-term gains. Isn't it worth $50 to wait a little longer to sell that investment?
There is one major exception to the short-term versus long-term tax issue: if you're holding your investments in a 401(k), IRA, HSA, or other tax-advantaged account, they won't be subject to capital gains taxes at all and you can sell those investments whenever you want without penalty (see the next section for more on how to use such accounts).
3. Not using an IRA or 401(k)
If you're regularly saving for retirement, good for you. But if you're putting the money you're saving into a bank account or standard brokerage account, you're missing out on a huge tax break. Retirement accounts such as IRAs, 401(k)s, and 403(b)s give you two important tax savings.
First, traditional retirement savings accounts, meaning non-Roth accounts, allow you to deduct all the income that you contribute to the account up to the annual contribution limit (though if you have access to an employer-sponsored retirement account, your IRA deduction may be limited). Since the annual contribution limit for 2017 is $5,500 for IRAs and $18,000 for 401(k)s, this can add up to quite a nice tax savings all by itself. For example, if you're in the 25% tax bracket, then maxing out your IRA contribution would save you $1,375 and maxing out your 401(k) would save you $4,500 on your taxes. Roth accounts don't give you a tax break on your contributions but instead allow you to claim your distributions tax-free, which can save you a ton on taxes during your retirement.
Second, all the various forms of IRA, 401(k) and so on give you a tax break on the money inside the account. All your investments in a tax-advantaged retirement account are immune from taxes on capital gains, dividends, and interest. This tax break can end up saving you a remarkable amount of money, especially for types of investments that normally generate large tax bills. For example, REITs are required to pay at least 90% of their taxable income out as dividends, which would normally be taxable every year -- unless the investor keeps his REIT shares inside a tax-advantaged retirement account.
4. Doing complicated tax returns yourself
If your tax situation is quite simple, then doing your own tax return makes a lot of sense. But if you've got a more complex setup -- say, a side gig that brings in self-employment income or lots of investment transactions -- you're better off having a professional do your return for you. In a complicated tax situation, you're likely to miss deductions and credits that you're eligible to claim and will pay too much in taxes as a result. Get a CPA or enrolled agent to do your tax return for you, and you'll likely see a huge savings compared to when you've done the return yourself. Plus, that'll save you the hassle of doing your taxes. No doubt you can think of some better uses for your time while the pro of your choice works on saving you money.
Many people make these expensive tax mistakes. By being aware of these pitfalls, you won't be one of them.