Financial Advisors: 5 Ways Market Swings Can Help You Save on Taxes
Watching your investments lose value during a volatile market can be frustrating, but a downturn may also create opportunities to reduce your tax bill. Financial advisors point to strategies such as tax-loss harvesting and Roth conversions that can potentially turn temporary market declines into longer-term tax advantages.
Read on for ways to turn that frown upside down in a downturn.
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1. Turn Investment Losses Into Potential Tax Savings
Nobody enjoys watching their portfolio temporarily decline in value when the market is volatile, but there is a silver lining known as “tax-loss harvesting,” according to Alex Michalka, vice president of investment research at Wealthfront.
Tax-loss harvesting involves selling an investment that has fallen below its purchase price to realize the loss, then investing the proceeds in a similar investment.
“Come tax time, you can use that loss to help lower your tax bill. And if you don’t have gains, you can offset up to $3,000 of ordinary income annually,” he said.
For example, according to Joseph M. Favorito, a certified financial planner (CFP) and managing partner at Landmark Wealth Management, LLC, pointed to a $100,000 investment in an S&P 500 ETF that falls 10% to $90,000.
“Selling it would realize a $10,000 loss, while reinvesting the proceeds in an ETF tracking a different index could keep the investor exposed to the market,” he said.
2. Use Losses To Offset Higher-Taxed Short-Term Gains
Tax-loss harvesting may be most useful for investors who have already realized short-term capital gains, which the IRS taxes as ordinary income. Michalka stated that investors can use realized losses to offset those gains. If they hold their replacement investments for at least a year before selling, any gains may then qualify for the lower long-term capital gains tax rate.
Another advantage is tax deferral. Michalka stated that an investor who uses losses to offset gains today may be able to postpone some taxes, leaving more money invested in the meantime.
3. Watch Out for the Wash-Sale Rule
Investors can’t sell an investment at a loss and immediately repurchase the same security without potentially triggering the “wash-sale rule,” Favorito said. The IRS requires investors to wait 30 days.
Replacement investments need to be selected carefully. The rule can also be triggered by identical securities purchased inside an IRA or Roth IRA, and even a spouse’s investment.
4. Consider a Roth Conversion When Investments Are Down
Market declines may create the right conditions to convert lower-value assets from a traditional IRA to a Roth IRA. A Roth conversion is generally taxable in the year you make it, so converting when an investment’s value is lower can mean paying taxes on a smaller amount.
Marc Lowe, a CFP and founder of In The Money Retirement Planning gave an example of 100 shares previously worth $10,000 declining to $8,000. Converting while they are worth $8,000 means the conversion is based on the lower value, though Roth conversions can increase overall taxable income.
5. Don’t Let Taxes Drive Your Investment Strategy
A tax break isn’t necessarily worth disrupting a sound long-term portfolio. Consider what the replacement security will be if an investor plans to stay invested.
“If your portfolio is properly constructed, the goal is to maintain the same risk profile and capture the loss," Favorito said.
This can be especially important with individual stocks, he stressed. Selling a stock to capture a loss means an investor may be unable to repurchase it during the wash-sale window without jeopardizing the deduction, potentially causing them to miss a rebound.
Perhaps the most important investment strategy is “staying the course,” Michalka said.
“Reacting emotionally to short-term market movements or trying to time the market often leads to poor outcomes.”
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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