Councilor, Buchanan & Mitchell is a full-service accounting and advisory firm in the Mid-Atlantic region in the Harness Wealth Advisor network. Below are some insights from Richard Morris, Executive Vice President and Director of Tax Services, and Alex Seleznev, Senior Investment Advisor and Chief Operating Officer of MBI, LLC.
When markets plummet, as they did by more 30% in March 2020, it can be easy to scramble for the exit and sell, sell, sell to avoid potential future losses. But aside from the fact that the markets have since nearly recouped all those losses (markets go UP as well as down), it can be easy to forget that selling when the markets are down can still mean you’re paying capital gains tax, especially if you’ve been invested for a while. And depending on your specific tax situation, you may be paying between 15% and 20% or even more in capital gain taxes.
More information here: How a Financial Advisor Can Help During Market Turbulence
Convert to Roth IRAs
You may want to consider converting a Traditional IRA into a Roth IRA. Any growth that accumulates in the Roth IRA is tax-free. For example, if you convert $50,000 and it grows to $100,000 in a Roth IRA over the next several years, that essentially results in $50,000 tax-free dollars. Keeping your funds in a traditional IRA only defers taxation on the full amount until the funds are distributed at some point in the future. This strategy is especially valuable for people who have made non-deductible IRA contributions as they may be able to convert a portion or even their entire Traditional IRA tax-free.
Adjusting your overall investment mix tax efficiently
As part of our regular investment reviews, we identify holdings for gradual liquidation. Some of these investments have high internal costs or have been underperforming when compared to their peers and/or benchmarks. Under normal circumstances, we would usually recommend that you liquidate such holdings over a period of two to three years to minimize the tax impact. In times of market volatility, you may be able to liquidate these earmarked investments with only limited tax consequences. As a result, you are able to bring your overall investment allocation closer to your desired investment mix much faster.
Harvesting capital losses for tax purposes
Market volatility also creates many opportunities to harvest capital losses for tax purposes. The harvested losses can be used to offset your future capital gains. The savings can be as high as 25 cents in saved taxes on each harvested dollar of capital losses (or even higher if used to offset short-term capital gains). These losses can also be accumulated for future years. Furthermore, up to $3,000 of your cumulative loss can be used to reduce your other income in years when you do not have any realized capital gains.
One important aspect of this approach is to ensure that your overall asset mix remains approximately the same after you implement this strategy. You will need to identify investment options for reinvestment of the proceeds that are similar to those you liquidate for tax purposes. Keep in mind the wash sale rule that would disallow the harvested loss if you repurchase the same investment within 30 days after the liquidation.
Consider exercising your stock options
Depending on the type of stock options you own—incentive stocks options (ISO) or non-qualified stock options (NQSO)—the decision to exercise would at least partially depend on the tax consequences. If you decide to exercise your options, you would owe taxes on the gain (i.e. the bargain element) between the exercise price and the market value. The market volatility may reduce the bargain element and make the decision to exercise more beneficial from the tax perspective.
It should be noted that analyzing tax consequences of exercising stock options is a complex exercise as it frequently involves the alternative minimum tax (AMT). Your ability to make the tax payments and overall investment allocation should also be considered when you make these decisions.
A number of tax savings strategies also exist through charitable giving and gifting assets.
Donor-advised funds (DAFs)
DAFs were all the rage in 2019 when the market experienced historic inflows and investors wished to lock in gains for charitable reasons. The concept behind contributing into DAFs is to use appreciated stock in a windfall year. The contribution of your appreciated stock into a DAF may not only reduce your income taxes but also eliminate the need to liquidate investments and potentially pay even more in capital gain taxes on the growth of your holdings.
Although turbulence and downward market trends in 2021 have led to losses that make DAFs a potentially less desirable strategy, it’s always a good idea to keep in mind such opportunities should the market take a significant upward swing.
More information here: Tax Benefits of a Donor Advised Fund
If you wish to support a relative or friend, transferring appreciated but temporarily depressed stock to them may be a good strategy in times of market volatility. You would be able to transfer more shares at lower prices.
This strategy is even more beneficial if your goal is to stay within the annual gift exclusion limit of $15,000 and your relative is in a lower tax bracket. Any future appreciation in price of the transferred stock would be in your relative’s account. Their tax burden may also be less if they are in a lower tax bracket.
More information here: Tax Strategy: Gifting Assets
Home Equity Line of Credit (HELOC) for home improvements
Finally, home improvements may also be more affordable during a down market. As markets dropped in 2020, the Fed reduced interest rates to essentially zero (the current rate range is between 0% and 0.25%, but is likely to rise soon). The result is a lower interest rate on a HELOC. You may also be able to deduct the interest of the HELOC you used to the make improvements to your home.
CBM has worked with many clients throughout this turbulent time to identify tax saving opportunities. Emotions should not be the primary driver for decision-making during a volatile market, since unwary investors may hurt themselves in the long run. Stay safe and be sure to take advantage of all opportunities available to you.