With heightened market volatility in recent weeks, it’s understandable that investors’ nerves are challenged. While it can be difficult to navigate in a down market, investors may be able to take advantage of tactical planning opportunities.
Here are six tax planning ideas to consider that may offer an advantage when stock markets fall.
1. Tax loss harvesting
Many investors and tax advisors typically harvest capital losses as the year-end approaches. However, they may miss out on sudden market declines during the year to adjust portfolios and harvest losses. In particular, there may be opportunities to conduct a tax swap between mutual funds. This entails selling one fund and investing in another that is similar. The strategy may allow the investor to realize a tax loss while retaining essentially relative equivalent market exposure. For example, selling out of an actively managed large-cap mutual fund or ETF and swapping it for a large-cap fund managed by another firm with a different portfolio structure. As long as the two investments are not considered “substantially identical,” then the wash sale rules prohibiting taxpayers from deducting losses would not apply. Investors should consult with a tax professional on their specific circumstances.
For more information about wash sales, read IRS Publication 550, Investment Income and Expenses (Including Capital Gains and Losses). Also, see more detail in our investor education piece, “Using investment losses to your advantage.”
2. Roth conversions
With many IRA values moving lower due to recent market declines, it may be time to consider a Roth IRA conversion. The lower the value of a traditional IRA right now, the lower the tax bill upon conversion, and the greater the opportunity for tax-free growth post conversion. Of course, other factors will apply in determining whether a Roth conversion makes long-term financial sense based on individual circumstances.
3. Gifting to family members
For higher-wealth individuals or couples considering gifts to other family members, now may be a good time. If account values have depreciated, it can result in a lower completed gift now, combined with the potential for longer-term appreciation after the gift is completed. This can present an opportunity to “freeze” the value of those assets now, and shift wealth from family members who may potentially be subject to the federal estate tax to heirs who are below the estate tax threshold.
4. Use IRA funds for charitable giving
When considering what type of asset or account to use to satisfy charitable wishes, taxable accounts with significant appreciation can be an attractive option. For example, by donating appreciated stock or mutual funds to a charity, the donor can avoid long-term capital gains tax. Conversely, donors generally should avoid donating depreciated, taxable property to charities. Since some account values may be lower right now, IRA owners over the age of 70½ may want to consider making charitable contributions with their IRA instead of tapping taxable accounts, which may have fallen in value. This option is also available to those who have inherited an IRA, provided they have reached age 70½. To learn more about this strategy, see “Donating IRA assets to charity.”
5. Convert UTMA/UGMA assets to a 529
Many families saving for college own custodial savings accounts, which may be subject to the kiddie tax rules. If those funds are earmarked for college, it may be a good time to liquidate those accounts and fund a 529. Selling out of an UGMA, which has fallen in value, could minimize any potential taxable capital gains when the account is liquidated. When the funds are placed within a 529 plan, clients may benefit from tax-free growth and tax-free withdrawals, assuming funds are utilized for qualified education expenses. Additionally, 529 accounts are treated more favorably than custodial accounts for federal financial aid purposes. Note that funds transferred from a custodial account to a 529 must be segregated from direct contributions to a 529. A beneficiary cannot be changed on 529 funds which were originally held within a custodial account. For more details see “Consider a reset of college savings with a 529 plan.”
6. Reset cost basis of company stock held within an employer retirement plan
The net unrealized appreciation (NUA) rule allows plan participants to potentially benefit from preferential tax treatment when distributing shares of company stock from the retirement plan. If executed correctly, the NUA portion of the company shares is taxed as long-term capital gains instead of ordinary income upon a sale of the shares. The greater the market appreciation of the shares held within the plan, the more attractive the NUA option will be. However, what about cases where shares of the company stock have declined in value? Participants holding company stock within a retirement plan that has decreased sharply in value may want to consider resetting the cost basis of that stock by selling the stock within the plan and repurchasing it shortly thereafter. We refer to this as the “Net Unrealized Depreciation” strategy. Unlike stock transactions outside of a retirement plan, the “wash sale” rule does not apply. Lowering the cost basis of the stock might improve the potential benefit of applying NUA treatment when distributing the stock from the plan in the future. To learn more see, “Understanding the NUA rule.”
Seek expert advice
Investors should seek expert advice from a financial professional with knowledge of their individual financial situations. Those taking actions that involve buying or selling assets or changing the type of an account through a conversion should understand the impact on their overall tax-planning strategy.
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