Tax Laws May Provide a Silver Lining during Market Downturns
With the deadline for filing 2019 federal tax returns postponed until July 15, and our main focus on staying healthy and safe, taxes are probably not top-of-mind these days. However, whenever the stock market falls, it can present tax-saving opportunities. Here are a few ideas that may provide a silver lining. As always, consult with your tax advisor to determine if any of these suggestions would benefit you.
Tax Loss Harvesting
When we sell securities at a loss in taxable, non-retirement accounts, the losses can be used to reduce taxable capital gains from other sales and may even reduce taxes on higher-taxed ordinary income up to $3,000 per year, with any excess carried over to future years. Although we may be harvesting losses on an ongoing basis, when the drop in prices is as widespread as it is, there are many more opportunities. If the loss is in a position that we still want to hold, we can buy it back after 30 days under the 30-day wash-sale rule. If we buy it back too soon, the loss will be disallowed. If we are concerned that we will miss a price recovery in the meantime, we can immediately buy a different security that generally moves in a similar direction. Exchange-traded funds that invest in the same industry as the stock that was sold can be used for this purpose.
If your income is in the 12% bracket, your long-term capital gains rate is 0%, so applying losses to your gains is not beneficial. Instead, you could harvest some gains and immediately buy back the stock, because the 30-day wash-sale rule does not apply to gains.
Reduction of Outsized Positions
There is a natural disinclination to pare back outsized positions with large gains because of aversion to paying capital gains taxes, even at a time when tax rates on long term capital gains are historically low. But when the value of that position is down, the cost in taxes of selling a portion is lower. Also, if your overall taxable income is in the 12% marginal tax bracket, you may not have any federal long-term capital gains tax liability at all. (Remember that this is not relevant in a retirement account in which securities can be bought and sold without tax consequences.)
Replacement of Tax-inefficient Mutual Funds
This again pertains to taxable, non-retirement accounts. Because mutual funds must distribute their dividends and capital gains each year, they’re not a tax-efficient position in taxable accounts, unless they are index funds, which generally have very low turnover in their holdings and generate few capital gains. Even though the distributions increase the tax basis, over time the unrealized gains may have built up and made us reluctant to sell the fund and pay the tax. When there is a drop in market value, the unrealized gain is lower and may even be negative, providing an ideal opportunity to unload the fund. You can then replace it with a diversified selection of individual stocks, which give you more control over the timing of capital gains, or exchange-traded funds, which usually have low distributions.
Gifting Securities
Although for most of us, the federal estate tax threshold is far higher than the value of our estates, the current levels will expire in 2026 and revert to the previous level, which will affect more estates. Also, many states have their own estate taxes. For that reason, if your potential estate is large enough, it may make sense to gift the maximum allowed each year to your heirs, which is now $15,000 per person. With stock prices lower than they were, and presumably lower than they will be in the future, it is possible to gift more shares of a particular security than you could have when the stock price was higher given the same amount of money. Be aware that when you gift securities, the tax basis is transferred as well, unless it is negative. So if you currently have a loss, better to sell the shares yourself and take the tax loss.
Roth IRA Conversions
Roth IRAs are the ultimate tax advantaged vehicle. The investments can grow tax-free, not just tax-deferred, and distributions are not taxed as they are with a Traditional IRA or 401(k). Furthermore, there are no minimum required distributions and a Roth IRA can be inherited without a tax liability when money is eventually withdrawn.
But the catch is that only after-tax money can be put into a Roth, and there are two ways to do that. The first is to contribute after-tax money in the first place, which means there is no tax deduction as with a Traditional IRA (for those who qualify). The other is to convert a Traditional IRA to a Roth IRA, which entails paying income taxes on the amount that is converted because it increases taxable income. It’s that tax bill, which should be paid from non-IRA money to make the conversion worthwhile, that discourages many of us from doing Roth conversions.
When the value of the securities in our Traditional IRA is down, it is less costly to convert them to a Roth IRA. Then when the price recovers, the increase will be sheltered in the tax-free Roth IRA. Remember that you can choose the individual securities that you want to convert, so you can convert only those you feel have the best “bounce back” potential. But be careful that you do not convert too much and push some of your income up into the next tax bracket or trigger a higher Medicare premium.
If you would have been required to take a minimum IRA distribution this year, you might consider converting that same amount to a Roth IRA instead, paying the tax you would have paid in normal times.
Special IRA Provisions in the Coronavirus Aid, Relief, and Economic Security (CARES) Act
- Suspension of Minimum Required Distributions
The CARES Act allows minimum required IRA distributions to be skipped in 2020. For most people who do not need the money to cover living expenses, that probably makes sense. But there may be situations where someone might not want to skip the distribution, such as if the individual will be in a particularly low tax bracket this year. However, a Roth conversion would probably be a better option than just taking the money if it is not needed now. - Liberalized Withdrawals and Rollovers from Retirement Plans
To qualify for the relaxation of certain rules pertaining to retirement plan withdrawals and rollovers, the CARES Act lists several specific reasons, including a coronavirus diagnosis in your family, lost work hours, or having to close your business, but there is also a catch-all category for “other factors” that may apply.
- If you are under 59 ½, you can withdraw up to $100,000 from your IRA without paying the 10% penalty, although income taxes would still apply.
- Regardless of age, you can withdraw up to $100,000 and pay it back over three years without paying income taxes. It’s like a 60-day IRA rollover, but you have three years instead of 60 days. If you do not pay it back, you can spread the income taxes over three years.
- If you are still working, you can take a loan against your 401(k) balance and delay payments for up to one year.
Details are yet to be released by the IRS and financial institutions as to specifically how these rules will be implemented and reported, as well as on whether the states will follow suit.
About The Author
Anne Christopulos
Anne is a Managing Director and Financial Planner with over twenty years of experience in the financial services industry. After holding corporate management positions in finance and strategic planning in New York City, she moved to Boston to become the Product Manager for the IRA business at Fidelity Investments. Following that, she was Vice President, Retirement Investments, at Fleet Financial Services. A native of Cape Cod, she returned to the Cape in 2001 and made the transition to personal financial planning with Secure Future Financial Services in Dennis and Davis Financial Services in Orleans before joining West Branch Capital. Anne holds a B.A. in music and economics from Wellesley College and an MBA from Harvard Business School.
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