By Sam Miller, CFA®, CFP®, CAIA®
Director of Research and Marketing
Turning Market Lemons Into Tax Lemonade
After the close of the first quarter, we reflected on The Three Black Swans (i.e., the Omicron variant, a war in Ukraine, and 40-year high inflation) along with their negative impact on global capital markets and investment portfolios.
At the time, most major stock and bond indexes were down more than 5%—providing little comfort for diversified investors. The selloff continued to accelerate through most of April and May, as the S&P 500® briefly flirted with bear market territory and losses mounted for bond investors in the face of rising interest rates. Currently (as of early June), the 2022 returns for a 60/40 portfolio are on track to be the sixth-worst over the last 100 years.1
After recent years of strongly positive stock market performance, 2022 has provided a stark reminder of the risks involved with investing—particularly around the more speculative corners of the market. We expect ongoing choppiness in the market as the Fed seeks to navigate the strongest inflationary pressures in more than a generation.
During these challenging times, it’s more important than ever to ‘stick to your plan.’ But that doesn’t necessarily mean sitting on your hands. While market returns have thus far been negative for most asset classes this year, savvy investors can potentially turn that into a positive from a tax perspective. You may want to explore one or more of the following strategies:
Tax loss harvesting
Volatile markets may offer an opportunity to use portfolio losses to create a tax asset. If securities in your taxable investment account have dropped below their original purchase price, you might want to consider selling them to harvest the tax loss. These losses can be used to offset gains and reduce your overall tax bill. If realized losses exceed your realized gains, they can also be used to offset up to $3,000 of ordinary income. And any unused losses beyond that can be carried forward to offset gains in future tax years.
For the first time in many years, 2022 could see significant losses in bonds and bond funds—presenting an even greater tax loss harvesting opportunity than normal. After a position is sold, it can be replaced with a similar security to maintain your asset allocation. But it’s important to consult with your advisor before making any replacement purchases to avoid running afoul of IRS wash sale rules.
Roth IRA Conversions
The decline in markets presents an opportunity to enact a Roth IRA conversion at a discount. A Roth IRA allows you to contribute after-tax dollars to a retirement account and enjoy tax-free appreciation and withdrawals throughout your lifetime—without any required minimum distributions (RMDs) like traditional IRAs.
A Roth conversion involves transferring pre-tax retirement funds from your traditional IRA into a Roth IRA (after-tax dollars). Therefore, you will need to pay tax on any funds you choose to convert. But remember, any future withdrawals from the Roth will be tax-free. To the extent IRA account balances have declined this year, the associated tax bill involved with converting assets to a Roth will also be reduced. Assets that you convert may then be able to participate in any future market recovery, resulting in a larger Roth account balance with less taxes paid in the process.
Currently, the annual gift-tax exclusion allowed by the IRS is $16,000 per person. In other words, you can gift $16,000 ($32,000 for married couples) to any individuals you wish without any tax implications. For example, you and your spouse could gift $32,000 to each of three adult children ($96,000 in total). But during a market correction, this annual gift can be further amplified. Gifting shares of stocks that have declined in value can enable the transfer of a greater number of shares while staying below the annual gift limits. In turn, these gifts potentially have a higher expected return today, simply due to lower share prices. And by accelerating stock gifting at lower valuations, you can remove the future growth of these assets from your estate (which in the long run may also help ease estate taxes).
As we approach the mid-point of 2022, both equities and fixed income investment have declined sharply, marking the most challenging start for diversified portfolios in decades. While it’s always good advice to ‘stick to your plan,’ you may want to consider taking advantage of market volatility to optimize your future tax situation.
Please reach out and talk with your advisor about these (or any other) tax and risk mitigation strategies as we prepare to navigate the road ahead.
1 60% S&P 500, 40% 10-year Treasuries
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