It’s impossible to predict when the next market downturn will occur, how deep it will go, or how long it will last. However, market dips can present good investment opportunities.
Loss harvesting is the strategy of selling non-retirement investments at a loss to yield a future tax benefit. Typically, when your investment portfolio goes up or down, you don’t owe tax on that shift in value until you sell or “realize” the investment gain or loss. Although it hurts to see your portfolio value down, this can be a productive loss harvesting opportunity. That’s because realized investment losses can be used to offset current or future realized taxable gains, dollar for dollar. For example, if you sell Stock A at a loss of $10K, and later in the year sell stock B at a gain for $10K, the loss from Stock A will offset the taxable gain from selling Stock B, thereby avoiding paying tax on the profit from Stock B. If you do not have a gain to offset in the same year, the realized loss can reduce your taxable income by up to $3K per year, with any unused loss rolling forward to offset gains in a future year. Harvesting losses today for a future expense can be a powerful tax savings tool.
To properly loss harvest, you cannot buy back the sold position for 30-days, otherwise the IRS will not recognize the loss – calling the transaction a “wash sale.” However, you can repurchase the same investment in 31 days. Alternatively, you can purchase a new investment. The new investment may be another mutual fund or it can be an Exchange Traded Fund (ETF), so long as it’s not considered substantially identical to the sold position by the IRS.
Roth IRA or 529 Savings Contributions
Gains inside a Roth IRA or 529 College Savings plan can be tax free if utilized properly. Therefore, if you believe that the stock market will recover by the time the Roth IRA owner is retired or the 529 student beneficiary enters college, a down market is a great time to buy stocks at a bargain! If you are gifting money to someone, consider putting some funds into their Roth IRA or 529 Savings plan. The annual Roth IRA contribution is limited to $6,500 in 2023 (or $7,500 for those age 50+) and the owner must meet income requirements.[i] For a 529 Savings plan, you can gift up to the 2023 annual gift tax exclusion of $17,000 per person. However, special 529 rules allow you to accelerate five years of gifting for a one-time tax free gift of up to $85,000 per person.[ii]
To super-size this strategy of putting assets into an investment with tax free growth, an IRA owner can do a Roth conversion, or a transfer from their traditional pre-tax IRA to an after-tax Roth IRA. Roth conversions are not limited by dollar amount, or income limits. However, transfer from an IRA to a Roth IRA are taxed as ordinary income, therefore you want to only convert what you can stomach to pay in taxes. This strategy is particularly popular if you think your income tax will be high in retirement, you want to avoid Required Minimum Distributions (RMD) in the future, or you are of the thinking that future tax rates will be higher than today’s rates.
With a little strategy and effort, some of these solutions can help you to turn lemons into lemonade. The goal is for you to harness the power of both up and down markets to benefit your investment portfolio in the long term. Please consult your CPA and your Certified Financial Planner™ prior to implementing these strategies to ensure your strategy aligns with your particular tax situation and your long-term investment goals.