In times of stress, it’s normal to want to do something; in fact, taking action is a recommended technique for dealing with stress.1 For this reason, it’s natural to want to change your plan, sell positions, or adjust your allocation during periods of market volatility. And over the past several months, many of our clients have asked us what actions they should be taking to protect their wealth. In almost every case, our answer has been the same:
While it doesn’t seem like it, “doing nothing” is a decisive action: it’s trusting your financial plan. And as we’ve seen during the dot-com crash in 2001, the 2008 financial crisis, and the COVID sell-off of 2020, sticking with a long-term investment strategy is almost always the right move, even if it’s uncomfortable at the time.
It’s with all of this in mind that I want to share three strategies that can enhance (not change) your financial plan during periods of market unrest: tax-loss harvesting, strategic gifting, and Roth IRA conversions. I’ve discussed a number of these topics before, but after the volatile start to 2020, now is a good time to revisit these items. If you have any questions about this information, please reach out to your team at Strategic Wealth Partners.
In an ideal world, your investments would never lose value. As the first half of 2020 has reminded us, however, we don’t live in an ideal world, and losses are a part of investing. Tax-loss harvesting is a strategy that allows you to capture some benefit from an investment loss.
When you sell an investment in a taxable account that has appreciated in value, you are required to pay capital gains tax. Tax-loss harvesting allows you to capture (or “harvest”) capital losses to offset your capital gains tax burden. But that’s not all: if your capital losses exceed your capital gains in a given year, you can apply up to $3,000 of capital losses to your ordinary income and carry any additional amount (beyond $3,000) into future tax years.
Our team can help you identify the positions in your portfolio that are ideal candidates for tax-loss harvesting, and how you can replace those sold positions to maintain your asset allocation strategy and avoid the IRS’ “wash sale” rule.
A “wash sale” occurs when you sell an asset and repurchase the same or a “substantially identical” asset within 30 days. This is crucial for tax-loss harvesting because the IRS does not allow you to claim capital losses from wash sales.
Tax considerations should never be the driving force behind your investment decisions. However, considering the volatility we’ve seen so far in 2020, tax-loss harvesting may help reduce your tax liability for the year.
Strategic gifting can be divided into two categories: family gifts and philanthropic gifts. Family gifts are ideal when the value of an asset is down but expected to eventually recover because the (temporarily) lower value of the gift means one of the following: 1) you can give more of something and stay within the annual gift exclusion amount of $15,000, 2) that you’ll use up less of your lifetime exclusion, or 3) that you will incur a lower gift tax. In addition, gifting an asset with a depressed value ensures that all future appreciation will occur outside of your estate.
Philanthropic gifts, on the other hand, are best made when asset values are high. If you plan to gift stock to a charity and the market tumbles, a potential alternative solution is to delay the gift until later in the year and give the stock price time to recover. If the stock price does recover, the charity of your choice will receive a larger donation — and you’ll receive a larger tax deduction.
Roth IRA Conversions
Another strategy that you can implement now to lower your future tax burden is converting a portion of your tax-deferred accounts to a Roth IRA. Tax-deferred assets that are moved into a Roth IRA are counted toward your ordinary income in the year of the conversion, so while the additional tax hit in 2020 may seem onerous, converting to a Roth IRA allows the funds to grow tax-free, and you won’t have to pay taxes on these assets when withdrawn. Even better, there are no required withdrawals from a Roth IRA, as long as you’ve held the account long enough.
Moreover, a down market can make a Roth conversion even more powerful. If you convert tax-deferred assets to a Roth when the investments are depreciated in value, the growth during the rebound will be captured tax-free.
A Roth conversion may be especially valuable if your income has been negatively impacted by business closures due to COVID-19. Since a Roth IRA conversion counts toward your ordinary income in the year it’s converted, a conversion when your income is lower than normal could be ideal.
These strategies may not be for everyone, and there are important tax and portfolio considerations for each. Used properly, they can be a great way to take action that will support, rather than undermine, your long-term financial plan. If you have any questions about implementing these strategies in your portfolio, we invite you to connect with the team at Strategic Wealth Partners.
1. Mayo Clinic, Need stress relief? Try the 4 A’s.