Published Wednesday, March 25, 2015 at: 7:00 AM EDT
Navigating the maze of investment tax rules isn't easy, especially when the law changes pretty much every year. And while tax-saving opportunities may present themselves, there also are little-known pitfalls that could increase your tax bill. Here are several tax traps, trips, and tricks to think about this year:
When you lose money on an investment sale you can use that loss to offset capital gains that you realize, plus up to $3,000 of ordinary income. But because long-term capital gains are taxed at a maximum 15% tax rate—or 20% if you're in the top income bracket—you're better off preserving such losses to offset short-term gains, which are taxed at ordinary income rates of up to 39.6%.
Tip: Take advantage of higher education tax breaks.
The Section 529 college savings plan is one of the most powerful tools in the tax law. It lets you set aside money in state-sponsored plans and avoid paying taxes on investment growth within your account. Then, withdrawals made for most higher education expenses are completely tax-free. Also, if there's money left over, or if the first child doesn't go to college, you can change beneficiaries or continue the account for a younger child. Yet while this college tax break is open to everyone, other breaks, such as higher education tax credits and a tuition deduction, are phased out for high-income parents.
Tip: Stagger a Roth conversion over several years.
The promise of future tax-free payouts is enough to convince many people to convert traditional IRA funds into a Roth IRA, even though that means paying a conversion tax. But you can reduce the pain of that tax by making a gradual conversion and avoiding the highest tax brackets. For instance, if you're normally in the low end of the 28% bracket, convert only enough to reach the upper reaches of that bracket, without pushing into the 33% bracket. Doing this for a number of years could help you convert all or most of your traditional IRA funds without dire tax consequences.
Trap: Making excess IRA contributions.
Generally, you can contribute up to $5,500 a year to any combination of traditional and Roth IRAs, or $6,500 if you're age 50 or over. However, the ability to contribute to a Roth is phased out for upper-income taxpayers. If you exceed the annual limit and you don't withdraw the extra amount by your tax return deadline, the IRS may hit you with a 6% excess contribution penalty, plus you'll owe tax on the earnings. What's more, the penalty continues to apply for every year you don't take out the excess.
Once you're past age 70½, you normally must take a required minimum distribution (RMD) every year from your employer retirement plan accounts and IRAs. RMD amounts are based on the value of your account balance and life expectancy tables. To make matters worse, the penalty for failing to take an RMD is equal to 50% of the amount that should have been withdrawn, but wasn't. Instead of leaving matters to chance, arrange RMDs well before the end of the year.
Trap: Breaking the wash sale rule.
The so-called "wash sale rule" prohibits you from claiming a loss on the sale of securities if you acquire "substantially identical" investments within 30 days of the sale. To avoid being washed out, wait at least 31 days to take a loss on the sale of securities you currently own. If you think the price of a particular investment may be about to rebound, you can buy the securities now and wait 31 days to sell your original lot. Note that there's no comparable tax rule for gains.
Trick: Use a thing called a NING.
The odd-sounding name is short for Nevada incomplete gift nongrantor trust. This sophisticated tax planning technique is based on creating a trust in Nevada, which, like just a handful of other states, has no state income tax. This effectively enables trust creators to avoid state income taxes in their home states. As a result, the NING has become a popular way to reduce taxes on sales of business interests and other large capital assets. Several other state variations exist.
These are only a few key suggestions. Huddle with your advisors to develop a comprehensive game plan that maximizes tax benefits and minimizes tax trouble.
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