This week, Gabe Adams, CFP®, MSPFP, shares three specific tax strategies worth considering when the market is down.

Transcript

Welcome to the weekly market update. As many of us are acutely aware, markets remain volatile. The S&P 500, broadly representing large US stocks, has dropped about 21% so far in 2022. Investment grade bonds, represented by the Bloomberg Barclays Aggregate Bond Index, have dropped around 12% year to date. It’s been a tough environment, with worries surrounding persistent inflation and rising interest rates, just to name a couple, dragging on stock and bond returns. With that backdrop, we’re going to discuss a few ways to take action. Namely, what are some tax strategies you can consider in a down market?

Strategy #1 – Roth Conversions

Let’s start with strategy #1 – Roth conversions. As some of you may be aware from conversations with your advisor, a Roth conversion involves moving funds from a traditional IRA to a Roth IRA. Funds in the traditional IRA grow tax deferred until withdrawn, at which point they’re taxable as ordinary income. Traditional IRA’s also have required minimum distributions, or RMD’s, starting at age 72. Roth IRA’s grow tax free and are not subject to RMD’s. However, while Roth conversions do move money into that tax free Roth IRA bucket, conversions are taxable as ordinary income in the year they’re made.

In all market environments, the tax benefits of Roth conversions depend on your personal situation. For example, if you expect to be in a lower tax bracket when performing the conversion versus later when the funds must be withdrawn from your traditional IRA, a conversion may be optimal. Often, a conversion can be optimal if you’re in the “Roth conversion sweet spot,” which represents the onset of retirement until you start taking Social Security and RMD’s. Additionally, conversions can make sense if you expect to have excess RMD’s or if you’d like to leave a tax free, Roth inheritance for your beneficiaries. It’s important to note that inherited traditional IRA’s and Roth IRA’s retain their tax qualities for your inheritors, and in most cases will need to be fully withdrawn within 10 years by non-spouse beneficiaries.

In a down market, Roth conversions can become more optimal for a couple of reasons. In a down market, your traditional IRA is at a lower balance, which then results in a proportionately larger conversion. Subsequently, when converting assets at depressed prices, the recovery in your Roth IRA grows tax free. Other than direct tax implications, there are some key pitfalls. First off, Roth conversions are irrevocable and can’t be undone. Also, by pushing your income over certain limits with the conversion, you could be subject to Medicare premium surcharges two years down the road. Finally, it’s important to note that Roth IRA’s have a “5-year rule” for withdrawals. Depending on your age, how long you’ve held your Roth IRA, and the holding period on your conversion, some withdrawals within a 5-year period could be subject to penalties and income taxes.

Strategy #2 – Tax Loss Harvesting

Strategy #2 is tax loss harvesting. This strategy involves purposely selling a position and realizing capital losses in a taxable, or nonretirement account. Realized capital losses, which amount to the difference between the current price and the cost basis, can offset realized capital gains. This can potentially help improve your portfolio. For example, capital losses could be used to trim concentrated positions with large gains. Combine that with the fact that you may already see a greater opportunity to unwind a concentrated position in a down market given current, reduced values. Outside your investment portfolio, capital losses could also offset realized gains from a real estate sale, after the last few years in which we’ve seen soaring real estate values. Capital losses not used in a given year can offset up to $3,000 in ordinary income, and the remainder carried forward into future tax years indefinitely.

A pitfall of tax loss harvesting is the wash sale rule. In short, if you sell a position for a loss and purchase a “substantially identical security” within 30 days, the realized capital loss will be disallowed. When replacing a position, your advisor can help ensure that you’re not purchasing a new position that’s deemed substantially identical.

Strategy #3 – Rebalancing

Although not necessarily a tax strategy per se, strategy #3 is rebalancing. Rebalancing is the act of bringing your portfolio back to its target allocation of stocks, bonds, and other assets. This can be done to sometimes great effect in a down market, as you can potentially buy growth-oriented assets like stocks at attractive valuations. However, after years of strong returns, it’s possible you may still have some embedded unrealized gains to contend with. With that, you can still reap the rewards of opportunistic rebalancing while being tax efficient. This would involve focusing on realized gains within qualified retirement accounts rather than your taxable, nonretirement accounts in which those gains would be reportable.

Now, it can be challenging to effectively implement these strategies, but we do proactively monitor them for you! We are currently rebalancing the Core portfolios, and our trading team, and your advisor, factor in the tax impact when making trading decisions. As you can see, Roth conversions can be a complex decision with potential consequences that can reveal themselves years, or even decades, down the road. Your advisor will be proactive if they think a Roth conversion makes sense in your situation. However, as always, don’t hesitate to contact them if you have questions or you want to explore a Roth conversion currently.

I hope this provides some silver linings in the current environment. Down markets can be painful even for the most experienced investors, but they can also present opportunities. Thanks for tuning in, have a great weekend, and join us next time for the weekly market update.

 

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