Shifting Your Tax Strategy With the Shifting Markets

Lately, our office has received quite a few phone calls from prospective clients thirsting for strategies to minimize the losses in their retirement portfolios. Folks, no doubt, we have experienced the worst beginning to the year—ever—in the history of the markets!

A few weeks back I wrote that the S&P 500 was down about 11 percent for the year, the Dow Jones Industrial Average the same, and the NASDAQ flirting with bear market territory. But even more telling about our current market situation is the performance within specific sectors of the overall markets. Get this, since the middle of last year, small cap equities are down about 24 percent, mid-caps about the same; international bonds are down around 12 percent, US bonds approximately 6 percent; large cap equities about 14 percent, and commodities have been free falling, well, they are down 55 percent.

Many of you have heard me explain that utilizing low risk, low volatility investment strategies to protect yourself in times of uncertainty is the cornerstone of any successful retirement plan. By managing the downside in the market cycle, the upside will take care of itself.

So, we would agree that talking about different investment strategies in times like these is important. But during a down market, you should be thinking about tax strategies as well as investment strategies. And at this time of year, as we rush to corral our W-2s, and start filing our tax returns, it’s as good a time as any to talk about some of these tax planning strategies that we can use to take advantage of the shift we have been seeing in the markets.

My first suggestion is to contribute to your retirement plans if at all possible. As you Richard’s Weekly readers know, this is something you can do every year to minimize your taxes and provide tax-deferred growth. But when the markets are down, you get the added benefit of using those dollars to buy into the market at lower prices, so the same amount of money contributed to such an account during a market downturn will actually buy you more than it will when the markets are trading higher. You still have time to contribute before the April tax-filing deadline.

While we are on the subject of IRAs, another tax-advantaged strategy that is especially effective during down years is the Roth conversion. If your traditional IRA or an old 401(k) has suffered losses, now may be a good time to execute a Roth conversion. Doing so will convert an investment that grows tax-deferred to something that grows tax-free. So, any future withdrawals will give you tax-free income. Remember that ordinary income tax is due on the conversion, but during a down market, that tax is based on a depreciated asset, thereby lowering your overall tax consequence. Make sure you consult your CPA or investment advisor before you do this to avoid any unintended tax consequences.

Another tax strategy that can be effective during times like these is to harvest some of the losses. Essentially, sell off some of your dogs. Now, you may think that selling a dog means taking a loss. Yep, you are right. But if you do not have confidence in your investment strategy, it may make sense to sell if that dog is in a non-qualified (taxable) brokerage account. As long as you do not purchase the same position within 30 days (called the Wash Rule), you can use that loss to offset future gains. So, at some point in the future if your new strategy shows a gain, you can offset those gains with your losses, thereby lowering future tax consequences. While these losses can’t be applied retroactively to earlier years, they will carry on and on and on into future years until they are used. On the other hand, even if you believe that your investment strategy is not a dog, that it still has breath and is not on life support, you may still consider selling your shares (at a loss), wait the 30 days, and then purchasing them back. Either way, when the shares rebound you may use those losses against future gains.

One last thing to think about when you are experiencing a deflated portfolio is the power of gifting. We are allowed to gift $14,000 to as many people as we want to every year. So if we believe that our investments are good investments and are just suffering a temporary setback, now may be the time when the gift of giving is most valuable. Let me explain. When the value of an asset is temporarily depreciated, you may be able to gift that asset and stay under the $14,000 limit, when you would otherwise exceed the $14,000 annual exclusion. Once the value of that asset rebounds, the gift can show its real value, without Uncle Sam taking out his share in the form of a gift tax.

So while evaluating your investment system in times like these is extremely important, you should also evaluate your tax strategies. Managing taxes must be a consideration when building a sound retirement system.