3 Tax-Saving Strategies in a Market Sell-Off
Nobody likes to see their account balances deteriorate, but there are some tax-saving strategies that can come in handy during periods of market turmoil. Luckily, these tactics only require a small amount of time and a basic understanding of the underlying mechanics.
Here are three money-saving tax strategies you can employ in times of depressed stock valuations.
Roth conversions tend to be a more advanced financial planning topic, but for most people, they're still useful to know about. 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 a post-tax retirement account (like a Roth IRA or a Roth 401(k)). When you perform a Roth conversion, the converted amount is added to your ordinary income for the year, which tends to meaningfully inflate your tax bill.
Market downturns present an interesting opportunity for Roth conversions. Because account values are down, the amount you have available to convert is less than it had been when the market was performing well. In these circumstances, if you do choose to convert money to a Roth account, you'll end up including a smaller amount as ordinary income on your tax return, thereby paying less tax on the conversion.
Imagine that you have $100,000 sitting in a traditional IRA and all of the money is considered "pre-tax" (i.e., you haven't yet paid tax on the money). If the market were to crash 40%, you'd be left with $60,000 in the account.
If you were to perform a Roth conversion after your account had declined, you'd add $60,000 to your ordinary income for the year -- rather than the $100,000 you'd add if you initiated the conversion when the market was higher. The big benefit here is that you only need to pay tax on $60,000 and you can keep the same number of shares that you had in your pre-tax account. When the market recovers, all of the money is tax-free forever.
If you've been meaning to sell a stock for some time and the market has turned south, you might be looking at a good opportunity to finally do it -- all while lowering your tax bill at the same time.
Recall that you're able to deduct capital losses on your tax return of up to $3,000 after netting for capital gains. To demonstrate this, imagine you sold a stock earlier in the year and realized a $10,000 gain on your initial investment. Then the market falls and you sell another stock, but this time you realize a $13,000 loss.
First, you'd "net" your capital gain of $10,000 with your capital loss of $13,000, leaving you with a $3,000 loss to deduct from your annual income -- thereby reducing your tax bill for the year.
Any losses in excess of $3,000 can be carried forward indefinitely, so you'd be able to apply any excess investment losses against future investment gains until your losses have been exhausted.
"Rebalancing" your portfolio means bringing the relative shares of stocks, bonds, and other assets back to your predetermined asset allocation percentages.
In other words, say you begin investing with an asset allocation of 60% stocks, 30% bonds, and 10% cash -- a moderate-risk portfolio. Because of a market downturn and a rally in bonds, you're now looking at a portfolio of 50% stocks and 40% in bonds, while cash has remained level at 10%.
In theory, this is a time to sell bonds and buy stocks, both to take advantage of lower stock prices and to get your own portfolio back in line with your risk and return objectives.
If you do decide to rebalance, make sure to do so in your retirement accounts as well. The reason for this is that you're able to trade to your heart's content in these accounts without any tax ramifications; trading in regular taxable brokerage accounts will likely cause some tax consequence, assuming you own investments that have appreciated over time.
Again, while nobody likes to see their money seemingly evaporate, there are some small things you can do to at least improve the structure of your portfolio 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 work wonders when it comes to tax planning, so it's worth learning about how to "play defense" when the market seems out of control.
This article was written by Sam Swenson, CFA from The Motley Fool and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to firstname.lastname@example.org.
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