Tactical Financial Planning & Tax Management
Market Volatility – What to do right now.
Tax Loss Harvesting & Roth Conversions
By: Steven Higgins, Financial Advisor, Principal
& Allie Schmidt, Financial Advisor, CFP®, CPA
Every investor is aware of the historically fast market downturn caused by the global Coronavirus event. The seemingly endless volatility has some investors shell shocked with many wondering what, if anything, they can do. While the context of this virus-driven event is unique, market volatility is certainly not. The S&P 500 has experienced many volatility events from the routine -10% correction to back-to-back -50% corrections in 2002 and 2009. While every volatility event has been followed by a hearty recovery, there can be a feeling of “this time is different” when we’re in the middle of it.
We all know that selling high-quality investments in a downturn is a terrible idea. Some investors take the ostrich approach and just stick their heads in the sand: the “I’m not even going to look at my account” approach. The ostrich approach is certainly better than selling. However, there’s another approach: the process and plan approach. Market volatility presents opportunities to investors who have a process and a plan. The most obvious is the sheer investment opportunity. Savvy investors know that the chaos of market panic historically provides for the best opportunity to buy high quality stocks at discounted prices. As part of our process at HD Wealth Strategies we have a pre-defined system that enables our clients to systematically buy stocks during volatility. So yes, we are buying stocks. But what else?
What can an investor do to wrestle the controls away from chaos and position themselves to be in the best position to reach their goals? At HD Wealth Strategies, we recognize that market volatility is a constant and our plans and processes reflect that reality. When asset prices drop, two of our go-to strategies are Tax Loss Harvesting and Roth Conversions. While an average investor may be familiar with these concepts, they likely do not have processes or the bandwidth to execute these valuable maneuvers in the face of market panic. As you would imagine, at HD Wealth Strategies we have both the processes and the bandwidth.
Tax Loss Harvesting
Who benefits the most?
- Investors with significant taxable accounts
- Real estate investors
- Employees with employer stock plans, Stock options, etc.
- High income earners.
- Business Owners
When an investment’s value drops below the price originally paid for the investment (the cost basis) there is an unrealized capital loss. If the investment is sold at a loss there is a realized capital loss. The IRS allows investors to use an unlimited amount of capital losses to offset current year or future capital gains. Additionally, an investor can use up to $3,000 per year of capital losses against ordinary income. While some folks might be so overcome with pessimism they can’t imagine a world with any capital gains ever again, capital losses can be carried forward forever. In 2009, during the “Great Recession” and the 55% associated market drop we remember clients telling us they didn’t need any more capital loss carry forwards because they didn’t think they’d ever use the stockpile they had. We’ll save you the details; they were incredibly wrong.
And there’s more! Capital losses can be used to offset capital gains in other assets as well. So, if you’re like many of our clients and you own investment real estate or a second home, harvest away and you’ll be glad you did come tax day…one day.
Cautions:
The IRS: It’s important to have professional guidance as the IRS imposes limitations on what can be taken as a loss. The Wash Sale Rule, for example, disallows losses for the the purpose of taxes if the same or “substantially” similar investment is repurchased within 30 days from the sale.
Emotions: This is not selling out of the market and shouldn’t be used to rationalize an emotional decision to “bail out”. For this strategy to work, the investor should sell one asset and instantly (literally) purchase another investment designed to maintain the same level of market exposure.
ROTH Conversion
Who benefits the most :
- Recent retirees not yet receiving social security or pension income.
- Investors who are overweighted in pre-tax savings vehicles (eg: 401(k)s and IRAs)
- Investors who anticipate having a higher tax rate later in life.
Taxes are one of the key motivators for financial decisions. Most people are motivated to avoid paying more tax than absolutely necessary. At HD Wealth Strategies, we see tax efficiency as one of the key areas where we can have an immediate impact for the benefit of our clients. While many of our tax observations are done so in an effort to reduce the tax liability of our clients, there are some situations where controlling when you pay taxes can reduce how muchtax you pay over time. The ROTH Conversion is one of those situations in which we recommend clients elect to trigger a tax event. During market volatility, the benefits of a ROTH Conversion can be even more pronounced.
A ROTH Conversion involves moving assets in an IRA to a ROTH IRA. Because IRA assets are pre-tax monies (you haven’t paid tax on them yet) the conversion is a taxable event, meaning you will pay ordinary income tax on the amount converted. Yes, we do this on purpose and it may save you money in the long run. The money you convert to a ROTH IRA will continue to grow tax deferred and withdrawals to you or your beneficiaries are tax free. Additionally, Required Minimum Distributions do not apply to ROTH IRAs, giving the investor more control over taxable income in the future. Younger retirees may be in the sweet spot to utilize this strategy as they are likely in a lower marginal tax brackets than in the past while working or in the future when they begin receiving social security or pension income.
Why now? With investment assets down over the last month, an investor is able to move shares at a reduced value out of an IRA and put those shares into a ROTH IRA. This allows the investor to move a larger number of shares out of the IRA (since prices are depressed) for the same tax burden on the conversion as opposed to doing the same thing when the stock market was at an all-time high. It is beneficial to have the investments recover the growth inside of the ROTH IRA, since that growth will be tax free. This can allow an investor to ultimately accumulate more assets in the ROTH IRA for a lower tax burden.
Cautions:
Tax Day Drama: A ROTH Conversion should be conducted by a professional. There are some administrative pitfalls that need to be avoided in order to avoid some tax headaches down the road. D.I.Y. at your own risk.
Cash for Taxes: It is ideal to pay the taxes resulting form the conversion with cash outside of the IRA. Using cash in the IRA to pay the taxes just increases the amount of the IRA distribution leading to higher than necessary taxes owed.
Hands off: The assets in the ROTH IRA as a result of a conversion must be left there for five years. If the assets are withdrawn before five years, there is a ten percent penalty on the gains only.
It’s easy for an investor to feel helpless during market chaos. Back in the day, investors had to wait for the monthly statement to come in the mail to take the toll of the damage. Investors certainly didn’t have every news organization on the planet in addition to social media screaming at them from the screen of their smart phone. It is truly hard for a smart successful person to manage a nasty situation where they feel they have little or no control. However, this is the moment where the planning, process, and strategies all go to work. While the concepts presented in this post, Tax Loss Harvesting and ROTH Conversions, may feel a little bit like making lemonade out of a huge basket of lemons, they are powerful strategies and reflect the professionalism of a prepared, focused, financial advisory team. At HD Wealth Strategies, we are built for this.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA.
