Took a huge hit on taxes this year? How investors can avoid a hefty bill next year

Published Wed, Apr 26 20231:39 PM EDTUpdated Wed, Apr 26 20233:40 PM EDT

Tax Day has passed — but there are still valuable takeaways from your tax return that can reduce the amount you owe Uncle Sam next year. Refunds declined sharply for this latest tax season, with eligible filers receiving an average refund of $2,840, down 8.5% from a year ago as of the week ending April 14 . Last year was a complex one for investors, as the sharp market decline seemingly left traders short of huge capital gains from dumping highly appreciated stocks. The S & P 500 shed 19.4%, and the Nasdaq Composite lost 33.1%. However, it's still possible to end up with an otherwise avoidable tax hit on your investments. "It's counterintuitive to people: Why do I have a large capital gains distribution this year? The market was down," said Tim Steffen, certified public accountant and director of advanced planning at Baird. "But we see it every time in a down market." Here are three situations that could have left you with higher taxes on your investments and how to reduce the blow next year. Active short-term trading Traders who actively buy and sell holdings in their taxable accounts can create short-term capital gains, which are taxed at the same rate as ordinary income. At the top income tax bracket, that marginal rate can be as high as 37%. Meanwhile, investments that you hold for more than a year are subject to long-term capital gains rates, which can be as high as 20%. People who got hit in 2022 include investors who made hay shorting the market. "It was great in 2022 because everything was down, but now you have all these short-term capital gains that are at the highest rate," said Jerrod Pearce, CPA and certified financial planner at Creative Planning. "Your shorting strategy did well, but now like half the money you made will walk out the door in taxes." Fixing this situation would require investors to rethink their goals: The tax impact is less jarring for investors who adopt a long-term mindset. It could also mean that tax-loss harvesting might make sense going forward. This means you sell a losing position to offset capital gains elsewhere in the portfolio, thus reducing the tax hit. Make sure you don't violate the wash-sale rule — a situation in which you sell at a loss, and within 30 days before or after the sale, you buy a security that's substantially identical. Unexpected capital gains Even responsible investors might find themselves caught off guard if they happen to hold a mutual fund that spins out a capital gain distribution. Actively traded mutual funds may have enough turnover to generate these distributions. But you might also see them in years when performance is lacking and fund managers sell holdings to cash out departing investors. In that case, shareholders who stick around receive a capital gains distribution from the fund. Investors may not find out about these unexpected distributions until late in the year. "You're not discovering it until mid- or late December," said Steffen. "If you don't notice until then, you're out of luck." Going forward, it helps to think about that fund's place in your portfolio. Would it make better sense to hold it in a tax-deferred account instead — where you would avoid the tax hit on distributions? If you're planning on buying a fund with a track record of spinning off distributions, think about your timing. "Don't buy into the fund before it makes those distributions," Steffen said. Botched retirement savings Fallen portfolios in 2022 created a silver lining for investors hoping to ramp up on retirement savings. You could convert sums saved in your traditional individual retirement account to a tax-free Roth IRA, and the taxes on the conversion would be lower due to depressed portfolio values. The benefit for the investor is that investments in the Roth IRA grow free of taxes and can be withdrawn tax-free in retirement, subject to certain conditions . Meanwhile, in a traditional IRA, taxes are merely deferred, but withdrawals are subject to income taxes. A backdoor Roth conversion is a variation of this strategy, wherein high-income savers make after-tax contributions to a traditional IRA and then convert those sums to their Roth IRA. But it's very easy for investors to botch the move and wind up paying hefty taxes. Here's where investors tend to mess up: The Internal Revenue Service requires you to consider all of your traditional IRA assets in order to figure out the taxes you owe on the conversion. This is known as the pro-rata rule. However, investors with multiple IRAs may overlook assets in one of these accounts. They might also convert assets early in the year and then roll money into an IRA from a 401(k) plan later in the year — which throws off the calculation for the taxes owed on the Roth conversion. To head this off in future years, be cognizant of the timing of your Roth conversion and make sure you work with an accountant to navigate the pro-rata rule and factor in all of your IRA assets. "If you're doing a backdoor Roth now, don't roll money into an IRA later in the year — that will mess it up," Steffen said. "You create taxable income you hadn't anticipated."