How People Lose Money Trying To Save On Taxes

By Liz Davidson | April 26, 2010 AAA
How People Lose Money Trying To Save On Taxes

My mother once offered me $10 if I could refrain from reaching out to grab groceries off the shelves during a trip to the supermarket. I was four years old at the time, and although grabbing groceries was the height of fun I abstained for that $10 reward. I didn't know what I would buy with it, but want it I did.

Thirty-plus years later things haven't changed much. The pull of a financial incentive is still there, and in that I am far from alone. In fact, it's human nature to be highly influenced by incentives - even when they end up costing us more than they're worth. This is especially true when it comes to taxes.

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Death and taxes are life's two inevitabilities, and both trigger strong feelings of loss that can hijack our decision-making. Paying taxes means more than forgoing income or losing money. It means handing over your hard-earned money to a government that's wasteful and with which you may often disagree.

In their zeal to avoid such a fate, investors often miss what really matters, which is their net profits rather than mere tax savings. Following is a list of the most common tax traps we see investors fall into as a result.

Trap one: Selling losers at year-end to offset capital gains.
In the short-term it makes sense to sell investments and take a tax loss to offsets a gain elsewhere, but the lure of taking a loss shouldn't drive your investing decisions. We've seen tax-driven investors sell stocks when they're down, only to wish they'd held on for the big rebounds that followed. Instead of harvesting tax losses willy-nilly, consider selling holdings whose investment thesis you no longer believe in, those you were planning to sell anyway or which throw your desired asset allocation out of whack. (For more insight, see Tax-Loss Harvesting For An Unsteady Market.)

Trap two: Holding onto winners to avoid taxes.
On the flipside, people often hold stocks far too long simply to avoid paying taxes on the gains. I have an employee whose grandfather was once worth millions but had it tied up in a single stock he refused to sell because of the large capital gains tax bill that would ensue. He succeeded in avoiding the tax - but only because the stock ultimately lost nearly all of its value. The inheritance he'd planned to pass on virtually disappeared.

Trap three: Letting tax considerations drive estate planning.
Minimizing taxes is an important part in estate planning, but far from the only one. In setting up a trust, it's vital to make sure you can live with its terms. A charitable remainder trust, for example, will provide tax-advantaged income in exchange for your charitable gift. The downside is that once you make the gift you can't undo it. Your lifestyle may be pinched afterward if the market declines and growth you were counting on to generate distributions fails to materialize.

Trap four: Misapplying tax rules.
One investor we talked to bought a vacation property with the intention of retiring there. After his plans changed he sold the home at a loss. Under the notion that he'd considered renting out the home prior to the sale, he then declared a capital loss on the home by claiming it was a "business" rather than a "personal" property. He danced to the bank with his refund check, but eventually had a nasty fight on his hands when the IRS called the maneuver into question. If you play fast-and-loose with tax law, be prepared to suffer the consequences.

Trap five: Taking a credit because it's there.
After Congress extended the Worker, Homeownership and Business Assistance Act of 2009, we witnessed a flood of people rushing to buy homes just to receive a tax credit. You should regard a credit as an added bonus - not a reason in itself to act. Instead, with the home credit, people have bought properties they can't afford, paid too much and failed to undertake proper inspections.

We adults get ourselves mixed up by incentive traps just like I did as a kid on a shopping trip. When making your important financial decisions, keep relatively small tax and other incentives in proper perspective and the big financial picture paramount in your mind.

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