(Sam Swenson, CFA, CPA)
No one likes to see their account balance deteriorate, but there are tax-saving strategies that can come in handy during times of market turbulence. Fortunately, these tactics require little time and a basic understanding of the underlying mechanics.
Here are three money-saving tax strategies you can use during times of declining stock market valuations.
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1. Consider a Roth conversion
Roth conversions tend to be a more advanced financial planning topic, but for most people they’re still useful to know. In short, a Roth conversion involves moving money (“converting it”) from a pre-tax retirement account (like a traditional IRA or a pre-tax 401(k)) to an after-tax retirement account (like a Roth IRA or a Roth 401(k)). When you do a Roth conversion, the converted amount is added to your ordinary income for the year, which tends to inflate your tax bill significantly.
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Market downturns present an attractive opportunity for Roth conversions. Since account values are falling, the amount you have available to convert is less than it was when the market was performing well. In these circumstances, if you choose to convert money to a Roth account, you will end up including a lower amount as ordinary income on your tax return, thus paying less tax on the conversion.
Imagine you have $100,000 sitting in a traditional IRA, and all of the money is considered “pre-tax” (meaning you haven’t paid any taxes on the money yet). If the market crashed 40%, you would have $60,000 left in the account.
If you were to make a Roth conversion after your account declined, you would add $60,000 to your ordinary income for the year, rather than the $100,000 you would add if you initiated the conversion when the market was higher. The big advantage here is that you only have to pay tax on $60,000 and you can keep the same number of shares you had in your account before tax. When the market recovers, all the money is tax-free forever.
2. Offset capital gains with capital losses
If you’ve been meaning to sell a stock for a while and the market has headed south, you may be looking for a good opportunity to finally do so, while lowering your tax bill at the same time. .
Remember that you can deduct capital losses on your tax return up to $3,000 after deducting capital gains. To demonstrate this, imagine that you sold a stock earlier in the year and realized a gain of $10,000 on your initial investment. Then the market falls and you sell another stock, but this time you make a loss of $13,000.
First, you’ll “clean up” your capital gain of $10,000 with your capital loss of $13,000, leaving you with a loss of $3,000 to deduct from your annual income, which will reduce your utility bill. tax for the year.
Any losses over $3,000 can be carried forward indefinitely, so you can apply any excess investment losses against future investment gains until your losses are exhausted.
3. Rebalance retirement accounts
“Rebalancing” your portfolio means bringing the relative shares of stocks, bonds and other assets back to your predetermined asset allocation percentages.
In other words, suppose you start investing with an asset allocation of 60% stocks, 30% bonds and 10% cash – a moderate risk portfolio. Due to a market downturn and a rally in bonds, you are now looking at a portfolio of 50% stocks and 40% bonds, while cash has held steady at 10%.
In theory, it’s time to to sell bonds and to buy equities, both to take advantage of falling stock prices and to bring your own portfolio back into line with your risk and return objectives.
If you decide to rebalance, be sure to do so in your retirement accounts as well. The reason for this is that you can trade at will in these accounts without any tax ramifications; trading in regular taxable brokerage accounts will likely result in tax consequences, assuming you own investments that have appreciated over time.
Market downturns can present opportunities
Again, while no one likes to see their money evaporate, there are a few things you can do to at least improve your portfolio structure during a correction. Ideally, these steps can help you build wealth faster and avoid higher tax bills along the way. Knowing the basic details of all three strategies can do wonders for tax planning, so it’s worth learning to “play defense” when the market seems out of control.
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