December is typically a low-key month in the stock market, which makes it the ideal time to do some portfolio housecleaning. While some tasks can wait until after the New Year’s Eve party, other chores (like topping off your workplace retirement contributions for 2015 and completing tax-slashing portfolio maneuvers) have a hard Dec. 31 deadline.
Mistakes can happen when investors face a time crunch, so we’ve composed this list to help you make the right year-end investing moves.
1. Avoid buying a mutual fund in December
Many actively managed mutual funds make their annual distribution of gains to shareholders — all shareholders — at the end of the year.
It doesn’t matter if an investor has owned the fund for 15 years or bought it 15 minutes before the distribution: If you own the fund in a taxable account those gains will be reported to the IRS and you’ll be responsible for covering the entire tax tab. (Note: Taxes on distributions don’t apply if you hold the fund in a tax-deferred account, such as a traditional IRA, or a tax-exempt one, such as a Roth IRA.)
To avoid paying taxes on gains that you didn’t have time to enjoy, wait until after distributions are made to invest in a mutual fund.
2. Hold off on cashing in your winners
IRS holding period rules reward (or, rather, penalize less harshly) those who hold onto their investments for more than one year. Investments in taxable accounts that are sold before the one-year anniversary are subject to a higher tax rate on gains than ones that have been allowed to simmer awhile.
Here’s how the 2015 capital gains tax rates are applied:
- Gains on investments that you’ve held for longer than one year considered long-term capital gains and are taxed at 15% for most people. (If you’re in a lower tax bracket you might not owe any taxes at all on your long-term gains. Those in the higher brackets may pay up to 20%.)
- Gains on investments sold at the one-year mark or sooner after purchase are subject to short-term capital gains tax rates and in most cases will be taxed at the higher ordinary income tax rate. If you are single and make between $37,451 and $90,750, you’re looking at a 25% or higher tax hit.
For those reasons, you want to be strategic about when you sell. But just as important is identifying the what and why behind your sales, which brings us to our next important “to do” before the calendar turns to 2016.
3. Check your portfolio balance
Reducing your portfolio’s volatility requires maintaining the right mix of assets — stocks, funds, ETFs or other investments — that don’t all react the same way to market events. That way when one type of investment hits a rough patch, you take less of a hit because the others balance out your returns.
Over time that balance can get thrown out of whack, which is why it’s important to review your allocation of assets at regular intervals. The SEC recommends that investors check their asset allocation every six to 12 months. But buying and selling can generate fees and trigger taxable events, and the SEC advises looking for ways to minimize those expenses wherever possible.
Some investment products and services automatically re-allocate holdings to maintain the proper balance for investors. Target-date or “life-cycle” mutual funds base the mix of assets on the amount of time investors have until they need the money in retirement. Holdings are adjusted to include more conservative investments as the retirement date draws near.
Many robo-advisors do the same thing with built-in rebalancing features that scour client portfolios — sometimes daily — to identify overweighted or underweighted holdings and take into account the tax consequences of each adjustment. Personal Capital, Betterment, FutureAdvisor and Wealthfront are among the robo-advisors offering automatic rebalancing.
4. Sell stinkers and use losses to offset gains
Restoring balance to your portfolio may require some selling and buying. If the investments are held in a taxable account, now’s the time to examine your holdings for tax-saving opportunities through a strategy called tax-loss harvesting.
Tax-loss harvesting is a way for investors to offset — or cancel out — any capital gains or income taxes they owe by applying capital losses against the amount. The IRS allows unmarried taxpayers and those who are married and filing jointly to offset as much as $3,000 a year in gains ($1,500 a year if you’re married and filing separately). Amounts over the limit can be carried forward into future tax years.
5. But avoid selling solely for the tax break
As nice as it is to put investment losses to good use, don’t let a short-term tax strategy usurp your long-term investing strategy. Selling a stock that shows promise just because it is has experienced a near-term loss robs you of future gains. (And if you’re thinking about turning around and buying it right back again, don’t: IRS wash sale rules will come back and ruin your New Year’s celebration.)
Before you sell an underperforming stock, identify whether it lost value due to a fundamental change in the underlying business. If not, then in most cases you’re better off letting the healing power of time and the magic of compound interest carry you back into the black.
6. Catch up on contributions to your workplace retirement account
You’ve only got until Dec. 31 to fully fund your workplace retirement plan — 401(k), 403(b), 457 or TSP. The contribution limit for 2015 is $18,000, or $24,000 if you’re 50 or older.
Those who haven’t fully funded the account throughout the year might have to devote the majority of those final 2015 paychecks to the cause. Talk to your payroll department about your options. If there’s not enough time for them to do the paperwork, see if you can send a check directly to the plan administrator so they can complete the contribution by the deadline. Also check to see if the company match (if you have one) applies to last-minute lump-sum contributions.
Scrambling and scraping up money may be a hassle, but it’s worth it — and not just to get your investment dollars in play. Remember, every dollar you contribute lowers your taxable income for the year. So this is a great year-end two-fer.
7. Do a Roth conversion, especially if you’re in a lower tax bracket in 2015
Spreading your investments across accounts with different tax treatments will give you flexibility when you start using that money to pay for expenses when you retire. For example, in flush years when you’re in a higher tax bracket it makes sense to take tax-free withdrawals from your Roth IRA. In years where you’re in a lower bracket, tapping your traditional IRA is smart because withdrawals are taxed at your ordinary income tax rate.
Now’s the perfect time to review whether it makes sense to convert all or even just part of your traditional IRA (or SEP or SIMPLE IRA) into a Roth. Because the conversion produces a tax bill (the money you roll over into a Roth counts as “earned income” for the year), ask yourself: Do I expect to be in a higher tax bracket next year? If so, it makes sense to pay the piper (less) now and do the conversion. See our roundup of the Best Roth IRA account providers.
If you expect to have less in earned income next year, you could wait to do the conversion. However, keep in mind that as earnings in the traditional IRA continue to grow, it will add to your income tax bill when you eventually do convert. And, lastly, if you’re a high income earner and don’t qualify for the Roth, look into doing what’s called a “backdoor Roth.”
8. Make your 2015 IRA contribution sooner rather than later
Even though the deadline for 2015 contributions to an IRA is Monday, April 18, 2016, it behooves investors to get ahead of the game and put those investing dollars to work ASAP. Every month you delay investing is another month of compounding growth lost.
Even if you don’t have $5,500 available to fully fund your IRA right now, sock away whatever you can (or open an IRA if you don’t have one already) in anticipation of the stock market waking up in January. It’ll be the best year-end gift you can give yourself for years to come.
This post was updated Dec. 21, 2015.
Image via iStock.