Zach’s 3 Biggest Tax Mistakes to Avoid in 2020
“Shut the front door please! We can’t afford to pay to heat the whole neighborhood!!”
Yep, those words came out of my mouth this weekend.
They say you know you’re old when you start yelling at the kids about turning the lights out, messing with the thermostat, or shutting the door to conserve electricity.
But seriously, I hate wasting money! And with seven kids running in and out of the house, it’s important to make sure everyone is doing their part to help us be smart with our money.
This time of year, our family can waste a lot of money very quickly if we’re not careful. I’m sure you can understand that feeling of shock when you open the electricity bill after a winter cold snap.
But as frustrating as a big utility bill can be, it’s nothing compared to the shock of a giant tax bill. So today, as we all start pulling our documents together for filing taxes, I want to share a few mistakes I’ve seen (or even made myself).
Hopefully these examples help you keep more of the wealth you’ve worked hard to build, so you have more money (and time) to focus on the things that really matter!
Mistake #1: Don’t be “Tax Smart, Investment Foolish”
Years ago when I was managing money at a private hedge fund, we had a client with some big investment gains.
Joe had invested some of his “play money” into a tech stock that wound up being a huge success! When Joe called my boss (and mentor) Bill to brag about his profits, the gains were somewhere around a quarter million dollars.
I distinctly remember Bill asking Joe what his exit plan was.
“You know Joe,” Bill said in his southern gentleman voice, “That stock has been on an absolute tear! But with no earnings, I wouldn’t be surprised if it traded back down soon. If I were you, I’d sell at least some of your shares now to lock in a profit!”
Unfortunately, Joe wasn’t convinced.
“Bill, that’s the dumbest thing I’ve ever heard!”
(Joe was a straight shooter and sometimes came across a bit rude.)
“If I sell my shares now, I’ll lock in a short-term gain. And you’ve seen my taxes Bill! I’ll wind up having to pay nearly half of my winnings to the government!”
So in what seemed like a tax-smart decision, Joe decided to hold on to his shares until he had held them for more than a year. That way, he could take a long-term gain on the position and pay a lower tax rate.
Except that a few weeks later, the company had a disappointing earnings announcement and the stock took a tumble.
Joe got his wish all right! He didn’t have to pay short-term capital gains taxes because he had no short-term gains. The stock wiped out all of his profits and Joe was mad as hell.
I still remember Bill pulling me into his office after a conversation with Joe.
“Never let this happen to you Zach,” he told me sternly. “We don’t make dumb investment decisions just to save a few percentage points on taxes.”
It’s a good lesson to remember — especially today when stocks are trading at all-time highs!
Mistake #2: Tax Shelters that Sound Too Good to Be True
This weekend, I had dinner with a few friends from my neighborhood.
The plan was to watch football and relax a bit. But whenever your little group of entrepreneurs, business owners, and investors together, the conversation always gets a bit intense.
This week a couple of the wealth managers in our group started talking about tax shelter strategies.
One of the guys started talking about state tax credits that you can buy on the open market.
“I tell my clients that you should only buy these tax credits if you like money. If you want to waste your wealth, then don’t buy tax credits.”
You could almost see the sarcasm dripping off his words.
The second guy started talking about a tax loophole tied to real estate conservation donations that investors can make.
“These were totally legitimate up until 2015. But I wouldn’t touch them today. The IRS is going to clamp down hard on any new deals.”
From there, the accountants and investors started arguing the merits and drawbacks of no less than a dozen different tax strategies. I was familiar with many of them. And some of them were new to me.
For my part, I sat back and literally took notes on my iPhone. There are a few interesting ideas that I’ll be researching (and of course letting you know what I find out).
The bottom line is that when it comes to tax strategies, the ones that seem too good to be true — usually are.
There are certainly ways that you can minimize or delay the amount of tax that you’re liable for. But we tread a very fine line here.
After all, we’ve got a legal, financial — and even a moral — responsibility to pay the tax that we owe. But when it comes to building and protecting our wealth, we want to be as efficient with those tax liabilities as possible.
Mistake #3: Wrong Strategy for Each Account
Here’s a mistake I made for several years until I started crunching the numbers more carefully.
It’s “common knowledge” that you should use the most conservative investment strategies in your tax-free or tax-deferred accounts like IRAs, 401(k) accounts and other retirement accounts.
On the other hand, most people use their taxable brokerage account for more aggressive plays. Typically, these are short-term investment strategies that can give us profits in a very short amount of time.
I understand the logic behind this mainstream advice.
Investment advisers want you to be conservative with your retirement account so you don’t take too much risk and wind up with losses before you retire.
But if you consider the fact that ALL the money you’re saving and investing will eventually be for retirement (or maybe already IS for your retirement), it really doesn’t matter what type of account your wealth is in.
What does matter is how those accounts are taxed. And taxes on short-term gains from our aggressive strategies can really take a bite out of your returns!
So for many investors, it makes more sense to hold long-term positions like bonds and dividend stocks in your taxable brokerage account. That way, your gains can grow over time. And if you hold positions for long-term gains, you should wind up paying a lower tax rate on those profits.
Meanwhile, if your short-term (and often more aggressive) gains are booked in your retirement account, those gains won’t be taxed until you pull the money out of those accounts. And in some cases, like with a ROTH account, you’ll never have to pay taxes on your profits.
Now I should mention that I’m not a tax professional. And your situation may be different. So it may be a good idea for you to double check this concept with your own tax adviser.
But for many investors, there are thousands of dollars to be saved simply by using the right type of strategy for the right type of account that your wealth sits in.
Now just to clarify, I’m happy to pay the taxes that I owe, and I’m thankful for the services that my taxes provide for.
But by being efficient with my taxes, I’m able to save more, grow my wealth more effectively, and donate more to the causes that mean the most to me. That’s a win all the way around!
So this year, please be mindful of the investment and tax decisions you’re making. Because wise decisions can save you thousands and give you a lot more flexibility with where you spend your wealth.
Here’s to growing and protecting your wealth!
P.S. Keep sending in your questions for my upcoming Q&A video series. These questions can range from “What’s my favorite dividend stock to buy right now?” to “What’s my process for finding and recommending winning investments?” Click here to add your question to the list!