It has been a painful year to be an investor. So far in 2022, the S&P 500 is down about 15% while U.S. Investment Grade bonds are down about 17%. Some individual sectors and companies have performed even worse.
While it’s never fun to see your account balances decline, market downturns can provide tax-saving opportunities that set your portfolio up for long-term success. Here are three tactical strategies investors can use whenever markets fall. Please speak with your own tax advisor before pursuing any of these strategies.
1. Tax Loss Harvesting
Tax-loss harvesting is the process of selling an investment that is currently valued at less than its purchase price. Once you sell, you realize the capital loss. What does it mean to “realize” a capital loss? As your investments go up and down, you'll have "unrealized" gains and losses based on your purchase price. You don't trigger a taxable event until you "realize" or lock-in those gains/losses based on when you sell.
When you realize a capital loss, this can be used to either 1) offset capital gains elsewhere in your portfolio or 2) deduct up to $3,000 in losses per year on your tax return. Any losses above $3,000 can be carried forward for use in future years.
The advantage of tax-loss harvesting is that investors can potentially realize tax losses while staying invested in the market. Eventually when the market recovers, you’ll realize the appreciation while also having tax losses to offset any capital gains elsewhere in your portfolio or to be used as write-offs on your tax returns in the future.
Investors must be aware of the ‘Wash Sale’ rule. This rule disallows a deduction for a loss from the sale of a security if you buy the same (or substantially the same) security back within 30 days. This window applies to both 30 days before and 30 days after the sale so investors must be aware of timing issues when considering tax loss harvesting.
2. Roth Conversion
A Roth IRA is a retirement account where contributions are after-tax and future distributions from the account are tax-free. In a Roth conversion, money is moved from a traditional retirement account into a Roth IRA. Assuming the distribution is a qualified distribution, the amount of money converted is taxed as ordinary income but there is no early withdrawal penalty. By converting when the market is down, you’ll pay less in taxes because you’re converting a smaller dollar amount. In addition, any future growth will be free of income tax because these assets will now be characterized as a Roth account.
3. Family Gifts
When you give securities to someone, the fair market value on the date of the gift is typically used as the amount of the gift for tax purposes. For 2022, the IRS allows everyone to gift up to $16,000 annually with no tax implications, but anything beyond that could impact your estate tax planning.
By gifting during a market sell off, you could potentially lower gift taxes by completing the transaction while the stock’s valuation is depressed. Any appreciation after the gift date is no longer in the donor’s estate and the new owner will pay taxes once they sell.
Losing money in the market is never fun but there are ways to take advantage of opportunities when sell-offs occur. These tax-saving strategies are an excellent way to ease the pain in an otherwise ugly market environment.
OneEleven Director of Wealth Coaching
Jason is a Certified Financial Planner™ and earned a B.S. in Economics from Penn State University and a M.S. in Accounting-Tax from Southern New Hampshire University. Jason worked on Wall Street for over 15 years and has always been fascinated with the stock market. Throughout his career, he has enjoyed sharing that passion with his clients. He also loves helping people with their finances so that they can live the life they’ve always wanted to live. Outside of work, Jason enjoys spending time with his wife and three young kids. He is an avid distance runner, huge sports fan, and amateur hot sauce maker.