Bear markets present tax planning strategies for astute investors. In this article we will explore how Roth IRA conversions and tax-loss harvesting may benefit you during this brutal investment environment.
A bear market is defined as a sustained drop of 20% or more of a major stock market index. These periods plague investment portfolios and make you question whether you should just stuff your cash under the mattress. What makes the current bear market more painful than usual is that long duration bonds are down more than most stocks.
We all have our share of money losing investments this year. How can we make these losses work for us?
Strategy #1: Roth IRA Conversion
A Roth IRA is a retirement savings vehicle, similar to a Traditional IRA, but different in a few important ways that make it extremely powerful. Contributions to Traditional IRAs are tax deductible, subject to income thresholds, whereas contributions to Roth IRAs are not. When funds are distributed from a Traditional IRA, they are taxed as ordinary income, whereas distributions from a Roth IRA are not. In both types of IRA, the undistributed gains are not taxed. (Read more about the differences between Roth and Traditional IRAs)
|Type of IRA||Deductible Contributions||Deferred Taxation of Gains||Required Minimum Distributions||Taxable Distributions|
|Traditional||Yes, subject to income limits||Yes||Yes, starting at age 72||Yes|
A Roth IRA Conversion is the process of transferring funds in a pre-tax account (Traditional IRA, SEP IRA, SIMPLE IRA or pre-tax 401k) to a Roth IRA. The conversion triggers additional income in the amount of the value transferred. As mentioned above, the main benefits are any future distributions are tax-free and required minimum distributions are not required.
There are many reasons why someone may want to perform a Roth IRA Conversion, but a key driver is the belief that their tax rate may be higher in retirement than it is in the year of conversion. This could be due to the level of their income or an expectation of higher statutory rates in the future.
A bear market presents an opportunity because stocks have historically bounced back after the financial clouds part and taxes are assessed at the depressed value. For example, an investor who converted a $100K IRA, value as of 1/1/2022, holding an S&P 500 ETF would owe $5,184 less at a 24% marginal tax rate and $6,912 at a 32% marginal tax rate if they had waited until 11/3/2022. If the S&P 500 bounces back to where is began the year, those gains are not taxed upon distribution from the Roth IRA.
|Date||Value of IRA||Tax Due @ 24%||Tax Due @ 32%|
Roth Conversions are taxed as ordinary income in the year of the conversion. Astute investors time their conversion to coincide with low-income years. While employment levels are still historically high, unemployment is likely to increase as the Federal Reserve raises rates to slow the economy and push down wage inflation.
In the above example, someone in the 24% marginal tax bracket who waited until 11/3 to perform their conversion would pay $13,184 less than someone in the 32% marginal tax bracket that performed their conversion at the beginning of the year.
Finally, make sure to reinvest the rollover proceeds once they are deposited into the Roth IRA! The benefit of performing the conversion during a bear market is that you pay tax based on temporarily depressed asset prices with the expectation that the value will recover when the market normalizes. If you do not reinvest the funds, you miss out on the recovery.
Strategy #2: Tax-Loss Harvesting
It is hard to get too excited about money-losing investments, but they do present an opportunity to lower your tax bill. Tax-Loss Harvesting is the process of selling an investment at a loss with the goal of reducing your taxes.
When stocks are sold at a loss, it is called a capital loss. Capital losses are categorized as short-term, held one year or less, or long-term, held more than one year. Capital losses may be used to offset capital gains. Gains and losses are first grouped and netted based upon their short-term or long-term nature. Any remaining capital gains or losses are then offset, regardless of their short-term or long-term nature.
Short-term capital gains are taxed at ordinary income tax rates, which are higher than the rates applied to long-term capital gains. The highest Federal income tax bracket is currently 35%, whereas long-term capital gains top out at 20%. This makes short-term capital losses more valuable to an investor that has short-term capital gains.
After short and long-term capital gains have been netted, any remaining net losses up to $3,000 may be used to offset your ordinary income. The remaining balance of capital losses are then rolled forward to future years to offset future capital gains or income.
Bear markets are the price of admission to participate in the attractive long-term returns of the stock market. Using a bear market to reduce taxes is an example of making lemonade out of lemons. Finally, before executing either of these strategies, you should consult with a financial advisor and tax professional to understand their impact on your unique circumstances.