Turn the market sell-off into a tax-smart advantage for your portfolio
War in the Middle East and surging oil prices have shaken stocks, but investors may be able to make hay even if their portfolios decline. The major averages have hit a rocky patch since the Iran war started on Feb. 28. The S & P 500 has fallen by more than 4% and West Texas Intermediate futures have soared nearly 40% in that period. On Friday, the Dow Industrials even briefly traded in correction territory – a 10% decline from a recent high. The tumult is likely to continue, too, especially with midterm elections coming up later this year. “We would expect to see some volatility going into the year already,” said Jamie Hopkins, certified financial planner and CEO of Bryn Mawr Trust Advisors. “These resets, even when they are brief – maybe there were some good corrections that occurred – that is a healthy thing.” But with the S & P 500 roughly 6% below its all-time high, investors can take a few steps to prepare for a tax-saving opportunity should declines worsen. Bulk up on tax-free savings A Roth conversion allows investors to convert some of the savings they keep in a traditional individual retirement account – where earnings are tax-deferred – to a Roth IRA, where assets not only grow free of tax, they can be withdrawn tax free in retirement too. There are two major benefits for making a Roth conversion in a falling market. First, when shares are at a depressed value, investors can move more of them into the tax-free account. Second, once the market rebounds, the appreciation will be sheltered within the Roth. That means beaten-up names with solid growth prospects – such as those in the tech sector – might be good candidates for a conversion. “If you believe that a recovery is coming to the market, maybe look at a conversion and let that recovery happen tax free in a Roth,” said Tim Steffen, CPA and director of advanced planning at Baird. Investors will want to work closely with their accountant and their financial advisor if they’re considering a Roth conversion. That’s because the amount converted is subject to ordinary income taxes — a marginal rate of as much as 37%. There’s also the risk that investors convert too much at once, which can have unintended consequences – like bumping them into a higher tax bracket or leaving them with higher Medicare premiums in a couple of years if they’re near retirement. Rebalancing and harvesting losses Investors with a heavy concentration in a certain stock that’s seen a sharp decline may be able to sell down some of their holdings at a lower tax cost and redeploy the proceeds elsewhere. “For those who are worried about rebalancing because of the tax cost, it got a little less expensive,” said Steffen. A related move that will get your portfolio back into balance: Realize some of your losses and use them to offset capital gains. If you wind up with more losses than gains, you can apply as much as $3,000 in losses against ordinary income. Additional losses can be carried over into future years. Just make sure that you avoid violating the wash sale rule. If you sell an asset to realize the loss, but then purchase a similar replacement within 30 days before or after that transaction, the IRS blocks you from taking the loss on your taxes. One asset class that has seen some sizable losses would be longer-duration bond funds, said Amy Arnott, portfolio strategist at Morningstar. “If you own a longer-duration bond fund, you still might have some pretty significant losses over the past five years,” she said. “Because there is so much uncertainty around inflation and interest rates right now, I think most people would probably not want to have exposure to long-term bond funds.” Short- and intermediate-term bond funds, which are less sensitive to interest rate fluctuations than their longer-dated counterparts, might be a better choice, Arnott said. Exercising employee stock options strategically Depending on your employer and the outlook for your company, a downturn in the market can also provide an opportunity to exercise employee stock options at a more favorable price point and a lower tax cost. Employees who exercise incentive stock options in a downturn may end up on the hook for a lower alternative minimum tax bill. How much this AMT bill comes out to will depend on the bargain element – that is, the difference between exercise price of the option and the fair market value on the date you exercise. When exercising options in a downturn, the spread will be smaller and so will the tax bill. Just be aware that you’re ultimately making a long-term bet on your employer, and it’s a decision that you’ll want to discuss with your accountant or your financial advisor. “This is a company-specific decision,” cautioned Steffen.
<
