Five Tax Errors Investors Commonly Make That Can Reduce Returns

Investors often lose money because of avoidable tax missteps. You don’t need to be an expert in the tax code to invest well, but learning a few basic rules can help protect your returns.

Below are five frequent tax mistakes investors should watch for.

1. Selling a Stock Too Soon

Even a single day can determine whether a gain is taxed at ordinary income rates or qualifies for more favorable treatment.

The IRS applies preferential capital gains rates to assets held for more than one year. Depending on income, those long-term capital gains rates can be 0%, 15% or 20%. By contrast, profits on assets sold after a year or less are generally taxed as ordinary income, with rates that can reach 37%.

For someone in the 37% bracket, selling a stock 11 months after buying it means the gain is taxed at ordinary income rates. Waiting just one more day to clear the one-year threshold could unlock the 15% long-term capital gains rate. On a $10,000 gain, that difference can mean $2,200 more in taxes.

2. Creating a Wash Sale

When an investor sells a security at a loss, that loss can help offset taxable gains or even reduce ordinary income by as much as $3,000. The catch is that the same investor cannot buy back the same or a substantially identical security within 30 days before or after the sale. Under IRS rules, that is a wash sale, which blocks the loss deduction.

One commonly missed detail is that the rule applies across all accounts an investor controls, including IRAs and a spouse’s accounts, according to Vanguard. So if an investor sells a losing stock in a taxable brokerage account and a spouse buys the same stock in an IRA during the 30-day window, the loss is still disallowed.

3. Missing a Required Minimum Distribution

Required minimum distributions are mandatory for owners of pre-tax retirement accounts such as traditional IRAs and 401(k)s. For 2023 and later, the IRS says these distributions must begin by April 1 of the year after a person turns 73.

If the full RMD is not withdrawn on time, the IRS can impose an excise tax of 25% on the amount missed, though that penalty may be reduced to 10% if the error is corrected within two years, according to the agency. For example, failing to take a $10,000 RMD could lead to a $2,500 excise tax, or $1,000 if corrected within the two-year window.

There is another cost as well. Once the distribution is eventually taken, it is still subject to regular income tax. For someone in the 24% bracket, that would add $2,400 in income taxes on top of the $2,500 penalty.

4. Not Keeping Track of Reinvested Dividends

Dividend payments are taxable even when they are automatically reinvested into more shares of a stock or mutual fund. For tax purposes, each reinvestment is treated as a new purchase with its own cost basis and holding period.

If those reinvestments are not recorded separately, tax problems can arise later. When you sell some or all of the shares, inaccurate records may leave the IRS assuming your cost basis is zero, according to FINRA, which can make your taxable capital gains look much larger.

5. Putting Investments in the Wrong Type of Account

To improve tax efficiency, different investments should generally be placed in the account that gives them the best tax treatment. Municipal bonds, for instance, are already tax-free and do not need the tax shelter of an IRA, so they are often better held in a regular taxable account. By contrast, dividend-paying stocks, interest-generating bonds, and actively traded funds or stocks may be better suited for a tax-deferred account such as a 401(k) or traditional IRA.

Where an investment is held does not change its underlying return, but it can affect how much of that return is lost to taxes before it has a chance to compound.