To paraphrase a popular bumper sticker, bear markets happen! Rather than bury your head, it’s moments like these that create some planning opportunities. Here are two bear market tax moves to consider.
Consider doing a Roth conversion when markets are down. Remember, the money invested in your IRA has not yet been taxed. But it will be someday. Fortunately, you are in control of when that moment arrives. What better time to pay those taxes than when the value of your IRA is temporarily depressed? Better yet, the IRS simply must accept a discount!
For the uninitiated, Roth conversions involve shifting – that is, converting – money out of your not-yet-taxed, traditional IRA and into a never-to-be-taxed Roth IRA. The amount you convert counts as taxable income.
Of course, while Roth conversions are smart when the value of your IRA is down, they become really smart when your conversion is taxed at a lower rate than it likely will be in the future. Figuring that part out requires some tax analysis skills along with a little bit of guessing about the future.
Now, Roth conversions are not an all-or-none proposition. They often are best done in smaller chunks and spread out over multiple years. You definitely want to be careful to not push yourself into a higher-than-normal tax bracket or trigger other oddities in our tax code.
Yet another bear market move involves your after-tax investments. Unlike your IRA that is taxed when you withdraw the money, the only items that result in taxes inside your after-tax accounts are your dividends, interest and the capital gains that you choose to realize when you sell an investment. Inside your after-tax accounts, the government doesn’t tax the chicken, just the eggs it produces.
Consider harvesting capital losses to use later on in the good years. If you look, you may notice quite a lot of yet-to-be-realized capital losses sitting inside your brokerage statements. You can harvest those losses for later use. The IRS will let you stockpile capital losses and carry them forward to offset your future gains.
To be clear, I’m not recommending that you simply dump a depressed investment just to realize a loss for future tax purposes. Instead, you could harvest losses and still leave your portfolio largely unaffected by (a) doubling your position in a depressed holding and then selling the high-cost shares after 31 days, (b) selling your depressed holding and waiting 31 days to buy it right back or (c) selling the depressed investment and reinvesting in something similar, but not identical.
Bear markets are hard to control and are often best ignored. But, when it comes to managing your taxes, Roth conversions and tax loss harvesting might satisfy your natural itch to take back a little control.
Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at [email protected] and at www.FrontStreet.com