On top of holiday preparations and celebrations in December, there are some year-end financial tasks that require attention. Many of those tasks on the financial to-do list have a tax component -- specifically, avoiding unnecessary taxes on your investments, or worse, incurring a penalty.
Here are some reminders of tax consequences to consider before the new year rolls around:
1. Watch taxes on mutual funds. Mutual fund managers regularly sell securities to rebalance or accommodate shareholder redemptions. That creates capital gains for shareholders, even those with an unrealized loss on their mutual fund investment. This is particularly true for actively managed mutual funds, which have greater turnover than index funds.
But even if you are the owner of a mutual fund with overall gains, you may have a tax consequence for gains that occurred before you purchased it.
"If you are invested in a mutual fund, and each year, whenever there are gains in that fund, as there have been for the last few years, the fund distributes those gains on an annual basis to whoever is the holder of the mutual fund at the time of distribution," says Steven Wallman, CEO of Folio Investing and a former commissioner on the Securities and Exchange Commission. "You end up with a very large potential tax liability, even though a good amount of that return might not have been yours."
A worst-case scenario can occur when a person buys a mutual fund just before the tax distribution is made, then sells shortly thereafter, Wallman explains. "You have incurred the taxes but haven't gotten much of the return. That's something people need to understand and think about. If you are investing in a mutual fund, it frequently does not provide an optimal tax result," he says.
2. Don't forget about required minimum distributions. By April 15 of the year after you turn 70 ½, you are required by the Internal Revenue Service to take a minimum distribution from qualified retirement plans, such as a traditional individual retirement account.
However, after that first year, your deadline for taking your distribution becomes Dec. 31. If you forget to take the distribution, you face an IRS penalty of 50 percent. In other words, if your distribution amount is $5,000, you would be hit with a $2,500 penalty. That's on top of the taxes you already pay on the distribution.
Jacob Gold, a retirement coach and financial advisor with Voya Financial Advisors, in Scottsdale, Arizona, says retirees can use different strategies for timing these required distributions.
For example, to create income throughout the year, a person could take 12 smaller monthly distributions rather than one lump sum. Or, for a person who has other income, such as a pension that covers living expenses, the required minimum distribution can be withdrawn toward the end of the year. Those taxes would be withheld, and the proceeds would be reinvested into an after-tax account.
When working with clients, Gold says, "If someone doesn't need the money, a lot of times we'll defer it until November or early December, because hopefully we've had some growth in the first 10 months of the year. The RMD calculation is done on the previous Dec. 31 value, so any appreciation on the year has built up in the portfolio when you take that RMD at the end of the year."
3. Don't let tax considerations get in the way of your investing goals. While it's imperative to have a tax strategy, always keep your investing objectives front and center. Jeanie Wyatt, CEO and chief investment officer at South Texas Money Management, headquartered in San Antonio, says decisions about when to buy or sell investments are often obscured by worries about tax consequences.
"In those situations, where people don't sell because they are going to have a tax cost, that can be a bad decision," she says. "You really have to know that the investment decision is No. 1 and the tax consideration is No. 2."
Wyatt cites the example of a person who has held a stock for a long period of time and paid a low price for it relative to its current price. "When an asset becomes 5 percent or 10 percent or more of your net worth, that is too much exposure," Wyatt says.
However, for a variety of reasons, people are often reluctant to sell a concentrated holding. In those cases, Wyatt says, do a rigorous analysis of the stock's prospects for the next few years, and then determine a strategy to gradually prune the holding and diversify into other investments.
4. Be cognizant of short-term capital gains consequences. A short-term capital gain is realized by the sale of a stock held for one year or less. These gains are taxed at the same rate as an individual's ordinary income.
A short-term gain can be reduced by a short-term loss. As much as $3,000 per year can go toward reducing taxable income. Additional losses may be carried forward into subsequent years to offset $3,000 in ordinary income or capital gains.
Going into the last few weeks of the year, "know where your realized gains are to this point, segmented by short term and long term," Wyatt says. "If you are going to have a big tax bill, consider if there are trades you can make to perhaps offset some of those gains if you have a loss in something that's short term."
5. Plan for future tax increases. Having a strategy for 2015 and beyond is crucial, says Beau Henderson, founder and CEO of the RichLife Group in Gainesville, Georgia. "One of the thieves that can steal your rich life is the real threat of future tax increases," he says.
People who have accumulated a sizable nest egg in their qualified retirement accounts will likely face a hefty tax bill when they start taking distributions. Henderson says effective planning today could potentially mean a lower tax bill down the road. "What if instead of pulling money out at a 35 percent tax rate, when you actually need to retire, it's taxed at 60 percent? That would affect your plan," he says.
Strategies to reduce a future tax burden could be as simple as redirecting some money to a Roth IRA, which is funded with after-tax dollars. Annuities or other insurance products may also protect money against tax increases down the road.
December is a good time to start thinking about ways to protect your investments from the tax man, Henderson says. "About now, people start thinking about the new year and having some goals and ideas," he says. "Everybody wants to do better and have a fresh start and do things more effectively in the new year."
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