Income tax benefits in a downturn.
Downturns are distressing for investors in part because of the unpredictability of the market. There are, however, potential tax savings in such challenging times. The tax strategies below help provide significant income tax savings in the current year and for many years to come.
Over the past forty years, 1982 to 2022, the Dow Jones Industrial Average has had six major downturns of over 20% decrease in value. Most of these downturns are due to exogenous events, those such as war, pandemic, etc. There are several tax saving strategies available:
1) Tax loss harvesting while avoiding tax wash sales.
2) Roth IRA conversion, especially for those expecting their income taxes to increase over the long-term.
3) Swaps from a mutual fund into a similar ETF for long-term tax efficiency.
Tax Loss Harvesting.
Tax loss harvesting means the selling of stocks, bonds, or mutual funds in order to reap the tax losses to offsetting gains realized in the same calendar year. In addition, one of the benefits to offsetting gains is the ability to carry over the excess losses over the gains to the next calendar year. In some situations, investors receive multi-year tax savings due to the carry over losses.
One caveat is to avoid what are known as “tax wash sales” which are disallowed IRS tax deductions. There are two ways to avoid the disallowed deduction: a) After selling the investment (stock or bond e.g.), the investor may keep proceeds in cash for 31 days after the sale to buy the same investment back. Please note: There is an exception to this rule. If the investor purchased the investment 31 days before selling it at a loss, they must wait 61 days after the sale to buy it back; b) After selling the investment, buy a similar investment but not the exact investment immediately to allow the investor to stay in the market rather than keeping cash and potentially missing an upturn in the market. For instance, if the investor sold the Vanguard 500 Index mutual fund, and purchased the Vanguard total market fund, they have avoided a disallowed wash sale and stay invested.
ROTH IRA conversion.
If you expect your marginal income tax rate to increase significantly in the future, converting your traditional IRA will save you substantial income taxes in the future. The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The tax savings can be significant over a ten or twenty-year period. For a taxpayer who currently is at the 12% tax rate, and who expects their tax rate to increase to 22% in the next five years, they would reduce their long-term tax bill by converting a portion of their regular IRA to a ROTH IRA up to and not to exceed their marginal tax rate of 12% per year.
Swap from a mutual fund into an equivalent ETF.
Swapping to ETFs from mutual funds is most helpful in a taxable brokerage account. Many ETFs annual management fees are lower than mutual funds with similar investment objectives. An ETF that invests in “small value” stocks compared to similar mutual funds may have lower annual fees. Small value stocks are those classified at the bottom 10% of the capitalization of the respective equity market and have a low price to earnings ratio, typically below the average of most Small Cap stocks. Capitalization is the total dollar market value of a company’s outstanding shares of stock.
And ETFs have annual tax advantages: ETFs per IRS rules allow the fund to exchange realized gains and losses that the ETF sold and minimize or possibly eliminate capital gains in the fund. Why is this an important tax benefit? Mutual funds by law are required to distribute to investors 95% of their realized capital gains on investments in the fund that are sold throughout the year. Even in market downturns mutual fund managers have realized capital gains when making changes to the fund’s portfolio. A client of our firm has saved $10,000 in income taxes annually by swapping from a mutual fund portfolio to an ETF portfolio.