Tax Planning Strategies During Market Declines
Every market has its own set of unique opportunities, and down markets are no exception. Equities have entered a bear market, which can put investors in a difficult position: when markets are volatile or declining, many investors feel compelled to take action in their portfolios by changing their strategy or selling their positions. Unfortunately, these moves rarely pay off.
However, there are still strategic steps you can take, especially from a tax planning perspective. In this article, we share six strategies that could help you capitalize on the current market decline.
As any experienced investor knows, losses are a part of diversified investing. Tax-loss harvesting is an opportunity to capture some value from those losses by helping to reduce your taxable burden.
When you realize a gain in the value of an investment, you incur capital gains tax. Tax-loss harvesting allows you to offset that tax burden by realizing—or “harvesting”—capital losses, which can be especially useful if you realized gains during the market’s post-pandemic recovery late last year. And if your capital losses exceed your capital gains in a given year, you can apply up to $3,000 of those losses to your ordinary income and carry any additional capital losses of $3,000 or more into future tax years.¹
Important to note: If you believe in the upside of a security that you have a loss in, you can always sell the security, wait 31 days, and then buy that security back. By waiting 31 days, you harvest the capital loss, avoid a so-called “wash sale”, and have now set a lower cost basis. As a result, you are in the same position as before the sale, but have captured a tax loss and now own the stock with a lower tax basis.
In the current bear market, conditions are ideal for strategic tax moves. We can help you review the assets in your portfolio and identify potential candidates for tax-loss harvesting.
Weigh your options for a Roth conversion
A down market also presents an opportunity to lower your tax burden in retirement through a Roth conversion.
Retirement accounts generally come in one of two forms: tax-deferred and taxable. Tax-deferred accounts are funded with pre-tax dollars, but withdrawals from these accounts are taxed as ordinary income (plus a 10% penalty if you take withdrawals before age 59 ½). Taxable accounts like Roths, on the other hand, are funded with money that has already been taxed, so withdrawals are tax-free in retirement. Tax-deferred assets that are moved into a Roth account are counted toward your ordinary income in the year of the conversion, so a market downturn—when their value is lower than it might be otherwise—is a particularly attractive time for a Roth conversion.
While this strategy does increase your tax bill in the short term, a Roth conversion means the funds will grow tax-free, and you won’t have to pay taxes on distributions from the Roth account in retirement.
Make charitable gifts from less tax-efficient IRAs
If philanthropy is important to you, a bear market presents a great opportunity to engage in charitable giving while also reducing your future tax burden. Donating appreciated stock held longer than a year is more tax efficient than using cash, since you get a fair market value deduction and avoid having to pay the capital gain tax on the built-in gain. However, even more beneficial for those over age 70 ½, is the ability to make a direct charitable transfer from your IRA to a qualified charity up to $100,000 per year. This is called a qualified charitable distribution (QCD). If you are required to make annual required minimum distributions, this payment counts towards your annual requirement and reduces what would otherwise be ordinary income taxed at ordinary tax rates for both Federal and many State taxes. If you are not yet subject to RMDs, but are older than 70 ½, you still are using ordinary income tax rate funds to meet your philanthropic needs verse capital gain rate dollars. Because of this, taking advantage of a QCD is typically the most tax efficient way to make donations as long as your ordinary income tax rate is higher than your capital gain rate.
Consider gifting/estate planning steps
If you have a taxable estate, now is a prime opportunity to leverage the down market through strategic gifting to family members, which will also help reduce the amount of estate taxes your loved ones will have to pay in the future. Gifting assets to family members while equity prices are down means you will pay less in gift tax than you would if you gifted those same assets during a market upswing.
The best equities to gift during a down market are those that you expect to recover or those with a strong upside, since the value of the gift will likely increase over time. On top of that, gifting the asset now while the value is depressed ensures that any future appreciation will occur outside of your estate, thereby lowering your overall estate tax burden.
Diversify concentrated positions
No matter the market conditions, investors always need to be aware of concentration risk. Holding a concentrated position in your portfolio is not inherently good or bad, but it does mean that your overall portfolio may be more vulnerable to market volatility. Understanding the quantity of concentration risk within your portfolio is the first step.
If you decide that you have too much concentration in your portfolio, the simplest way to lower concentration risk is by selling some of the concentrated position and diversifying, but when prices are high, that means incurring a much higher capital gains tax on the sold assets.
A declining market may be an opportunity to rebalance your portfolio and diversify those concentrated positions while minimizing how much you will pay in taxes for doing so. And as noted above, there are ways to further reduce the tax hit, such as donating appreciated positions or gifting stock to family members.
Time your contributions to tax-deferred accounts
In normal market conditions, attempting to time the market is historically less successful than simply contributing to your accounts at regular intervals. However, that thinking may shift during a market that is moving lower.
Employees in company-based plans have great latitude regarding the timing of their contributions to employer-based plans. While some employees frontload contributions to get them “out of the way”, most spread their contributions ratably over the year. One advantage of the ratable method is that that you are laddering into the market which helps avoid timing issues as one is slowly taking advantage of the market volatility. Whether you front load or use the ratable method, you also have a choice of when to invest in the account. In long-term down markets, you also have the ability time how and when you make investment choices in more volatile asset classes such that you can be more conservative with new dollars initially and then reallocate when you think the market risk might be lower. Market timing is generally frowned upon, but remember, in retirement accounts there is not tax advantage of taking losses other than having less dollars to eventually take as taxable distributions.
A market decline can be challenging to navigate, and it’s important to avoid taking any action that doesn’t support your long-term wealth management objectives. The strategies outlined above are a great way to make a down market work to your advantage and support your long-term financial plan. As always, if you would like to discuss how Telemus can help you effectively navigate this challenging investment landscape, don’t hesitate to get in touch with our team.
¹ Forbes, Can Tax Loss Harvesting Improve Your Investment Returns? (Link)
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Andrew has been a member of the Telemus team since its inception in 2005. As the Chief Wealth Officer, Andrew is responsible for all strategic financial and life management services. He works with high-net-worth members to ensure their financial life plans are designed to achieve realistic goals in both the short and long term.