8 Tax Pitfalls to Avoid: Smart Strategies for Financial Success

When it comes to taxes, most people worry about major mistakes that could land them in trouble with the IRS. However, the most common pitfalls fall into two categories: human errors and missed opportunities to reduce tax liabilities. While minor mistakes might result in a notice from the IRS, overlooking tax-saving strategies can be far more costly. By taking the time to understand these pitfalls and seeking professional advice when necessary, you can protect your financial well-being.

Here are eight common tax pitfalls to avoid:

1. Missing Investment Income

Your salary, bonuses, and other earned income are reported to the IRS, and so is your investment income. Any earnings from capital gains or dividends exceeding $10 generate a 1099 tax form from your investment firm. If you forget to report this income, the IRS will likely catch the omission and issue a notice.

A common misunderstanding is assuming that reinvested dividends and interest are not taxable. In reality, while you won’t owe capital gains taxes until you sell an investment, any distributions received during the year are taxable—even if reinvested. To avoid missing investment income, keep track of all investment accounts and verify that you have received all 1099 forms before filing your return.

2. Selling Investments Too Soon

Understanding how long you’ve held an investment before selling it can significantly impact your tax rate. If you sell an investment after holding it for a year or less, any gains are taxed as ordinary income, which may be significantly higher than the long-term capital gains tax rate. For example, if you are in the 22% tax bracket, you could be paying 7% more in taxes compared to the 15% long-term capital gains tax rate.

Additionally, high earners making over $200,000 as a single filer or $250,000 for married couples filing jointly may also be subject to the 3.8% net investment income surtax. Timing your investment sales wisely can help reduce your tax burden.

3. Poor Recordkeeping

The amount of gain or loss you report on the sale of an investment depends on the sale price minus your cost basis (the amount you originally paid for the investment). The IRS requires financial institutions to report adjusted cost basis for covered securities, but taxpayers must still report their transactions on IRS Form 1040, Schedule D, or Form 8949.

Failing to keep accurate records could result in overpaying taxes or struggling to substantiate your claims in case of an audit. Keep detailed records of all investment purchases, dividends, and reinvestments to ensure accurate tax reporting.

4. Forgetting to Claim Investment Losses

If you have investment losses, you can use them to offset capital gains and even deduct up to $3,000 of ordinary income ($1,500 if married filing separately). Unused losses can be carried forward to future years.

Many taxpayers forget to claim these losses, missing a valuable opportunity to lower their taxable income. Make sure to review your investment statements carefully and work with a tax professional to optimize your tax situation.

5. Waiting Too Long to Plan Your Tax Strategy

Many investors wait until tax season to review their financial situation, but strategic tax planning should be an ongoing process. One valuable tax strategy is tax-loss harvesting, which involves selling investments at a loss to offset capital gains. However, this needs to be done before the end of the tax year.

By regularly monitoring your investment portfolio and consulting with a financial professional, you can take advantage of tax-saving opportunities throughout the year rather than scrambling at the last minute.

6. Engaging in Wash Sales

A wash sale occurs when you sell an investment at a loss and repurchase a substantially identical investment within 30 days before or after the sale. The IRS disallows these losses for tax purposes, meaning you cannot claim the deduction for the loss in the current tax year.

If you frequently buy and sell investments, be aware of wash-sale rules to avoid losing out on tax benefits. Note that these rules currently do not apply to cryptocurrencies, offering a unique tax advantage for digital asset investors.

7. Not Taking Advantage of Tax Breaks

Missing tax deductions and credits can cost you significant savings. Tax credits reduce your tax bill dollar-for-dollar, while deductions lower your taxable income.

For example, the Child Tax Credit allows eligible taxpayers to claim up to $2,000 per child, directly reducing the amount of taxes owed. If you are in the 24% tax bracket and itemize deductions, a $1,000 charitable donation could reduce your tax bill by $240.

Many deductions and credits have specific eligibility requirements, so consulting a tax professional can help ensure you claim all the tax breaks available to you.

8. Forgetting Tax Deadlines

Certain tax-deductible contributions, such as mortgage interest, 401(k) contributions, and student loan interest, must be made by December 31 of the tax year. However, some deadlines extend into the following year—such as contributions to tax-deductible IRAs, Roth IRAs, and Health Savings Accounts (HSAs), which can be made up until the tax filing deadline.

Missing these deadlines can result in lost tax-saving opportunities, so it’s crucial to keep track of important tax dates and plan accordingly.

Bottom Line

Tax mistakes happen, but with careful planning and attention to detail, you can minimize errors and take full advantage of tax-saving opportunities. Even if you use tax software or hire a professional preparer, reviewing your financial situation and understanding key tax rules can help you avoid costly pitfalls.

Consider tax season as a chance to assess your overall financial health and explore ways to lower your tax liability. Every dollar saved in taxes is another dollar that can be invested in your future. With a proactive approach, you can navigate tax season with confidence and maximize your financial well-being.