By Cory Cuffley, CFP®, CPA, C(k)P®, CRPS®, AIF®
It has been an uneasy year for the market thus far, with the S&P 500 and NASDAQ down significantly from late 2021 highs. It is never a good time to see declining account balances, but losses offer an opportunity to employ tax strategies that can help ease the pain.
Here are three moves to consider.
1. Tax Loss Harvesting
When an investment is sold for less than its purchase price in taxable accounts, the dollar amount of the difference is called a capital loss. A losing investment must be sold in order to realize, or “harvest,” the loss. Holding a position as it loses value does not allow an investor to report the loss. Any realized loss can be netted against gains realized in the same tax year.
For example, an investor with $5,000 in realized capital gains and $3,000 in realized capital losses would only be taxed on $2,000 of income. If realized losses exceed gains, an investor can deduct up to $3,000 of losses from earned or other income. The excess losses can also be carried forward to deduct from income or offset gains in future tax years.
Selling an underperforming investment may be advantageous, but it may also impact the balance of the overall portfolio. To maintain a portfolio’s allocation, you may sell a position to lock in the loss, then purchase a similar investment with the proceeds. Such moves are common between exchange-traded funds (ETFs) and mutual funds as several products often track the same or similar indexes.
However, you must be careful not to buy the same investment that was just sold at a loss. IRS rules require an investor to wait at least 30 days before purchasing the same asset that was sold at a loss. If the same asset is bought within those 30 days, it is considered a “wash-sale,” and you will lose the ability to write off the loss.
2. Roth IRA Conversions
A Roth IRA can be a great option to hold your retirement savings. Unlike with a traditional IRA, you will not pay taxes on the money you withdraw as long as you follow distribution rules, nor will you be required to withdraw a portion once you reach a certain age.
While you can’t make contributions to a Roth IRA if your income exceeds a certain amount, you can convert traditional IRA assets into Roth assets. Conversions are most commonly completed by directing the financial institution that holds your traditional IRA to transfer funds to a Roth account. Transfers can be done between accounts at the same institution or from one institution to another.
There are tax implications to be aware of when considering a Roth conversion. When you convert your traditional IRA, you will owe taxes on any money that would have been taxed at the time of withdrawal. This includes tax-deductible contributions and any funds that have grown on a tax-deferred basis within the account. These funds are taxed as income in the year you make the conversion. You can convert as much as you want in a given year; however, it may be wise to spread out large transfers to avoid moving into the next tax bracket, especially if you are retired and are now in a lower tax bracket than you were previously.
You may have one or more IRAs funded with pre-tax and after-tax contributions. When considering a Roth conversion, you are not permitted to convert only after-tax contributions in an attempt to circumvent tax liability. Any conversion to a Roth IRA is taxed pro-rata in accordance with the taxable percentage of all IRA contributions.
For example, suppose an investor has an IRA with a balance of $50,000 in after-tax contributions and a second IRA with a balance of $150,000 in pre-tax contributions. For taxation purposes, 75% of those contributions are subject to tax. This means that if the investor converted $50,000 from the after-tax account into a Roth, the taxable portion would be 75%, or $37,500.
Considering the above factors, Roth conversion may not suit every investor. Still, a down market can present a good opportunity to consider a conversion. The value of assets within your traditional IRA is likely lower in these market conditions, equating to a lower tax bill upon conversion.
3. Combat Embedded Capital Gains from Mutual Funds
Mutual funds can be useful investment vehicles, especially for the average investor. Typically, mutual funds must distribute capital gains to their investors. They do this in the form of cash or additional shares paid to shareholders, usually around the end of the year. Regardless of the form selected, these distributions are taxable when the funds are held in a taxable account. In years when the market is doing well, this distribution and tax could be large or small, but what may be a surprise is that funds can also pay out large distributions in down years.
During market downturns, many wise investors stay the course or even invest more money for the eventual upswing. Conversely, some investors panic and redeem their mutual fund shares for cash. Upon redemption, the mutual fund must provide investors with cash, which means they must liquidate some of their positions. This liquidation causes a capital gain or loss that could be distributed to the holders of the fund.
Imagine hypothetical mutual fund ABC bought a security 10 years ago at $5 per share. Now, due to redemption requests, the fund must sell the security at a current price of $25. A holder of ABC would incur their share of the $20 taxable gain at the end of the year. The situation could get worse if shares of the mutual fund decline in value throughout the year. Now an investor will have a losing position in the fund and still be forced to pay taxes on the embedded capital gains from the above scenario.
There are ways to minimize exposure to the above scenario. When mutual fund managers make trades within the fund, they do not become taxable to the investor until they are declared near the end of the year. A wise investor may sell the mutual fund prior to the declaration of capital gains to avoid the distribution, assuming they do not want the added taxable income. That said, if the fund is held at a substantial gain, it would be wise to hold it through the distribution, as selling it would create a taxable gain. Conversely, if the fund is held at a loss, selling it to avoid the distribution and realize a loss may be advantageous.
Similar portfolio allocations can be achieved through investment in ETFs rather than mutual funds. ETFs are pooled investment vehicles that operate much like mutual funds but rarely distribute capital gains to investors.
Contact Us for More Insights
Down markets can be difficult to watch, but wise investors can make the losses less painful through advantageous tax strategies. For investment advice or more information on the topics above, reach out to your local financial advisor at Stonebridge Financial Group, with offices near Harrisburg and Lancaster.
Cory’s primary responsibilities include working with the firm’s corporate retirement plan clients, providing participant education, and business development. He holds a master’s degree in Accounting and Professional Consultancy, and recently was honorably discharged as a member of the Pennsylvania Army National Guard. Cory enjoys spending time with his wife Megan, their daughter Claire, and their two dogs.