Roth Conversions and Tax-Loss Harvesting: 2 Strategies to Leverage in a Down Market

investment strategies

By Ryan Yamada, CFP® on Carson’s Advanced Solutions Team

As the market tumbles, your confidence can, too – especially if you see your investments lose value.

You’ll be tempted to make rash decisions, and if panic rules the day, you’ll likely regret your choices. As any wise financial advisor will counsel you, it’s important to think long-term. Lean into your financial plan, not away from it.

But keeping an eye toward the future doesn’t necessarily mean you should sit back and take a passive position. There are strategic moves to be made in a downturn.

Let’s dig into two key strategies investors should consider during a market downturn: tax-loss harvesting and Roth conversions.

Tax-Loss Harvesting

Tax-loss harvesting is a strategy in which investors sell low-performing, taxable investments and use the loss(es) to offset gains, thereby lowering their taxable earnings.

Say you sold a few of your investments at a loss when the economy sputtered, but your portfolio is otherwise up on the year. Claiming the loss can lower your taxable income.

If your losses exceed your gains, you can claim up to $3,000 on your taxes to offset your ordinary income.

You can also carry losses forward to neutralize future capital gains – a real advantage when the markets rebound and your investments start seeing serious growth.

Who stands to benefit the most from this strategy?

It is a particularly useful tool for those in higher income brackets, since the idea is to lower your taxable footprint. (Investors in low tax brackets already enjoy a lower tax rate.)

If you’re in a lower tax bracket, you could carry the losses forward to leverage when you expect to otherwise owe more – because you were promoted or the government raised taxes, bumping you into a higher bracket.

Or perhaps you’ve had some great gains in the past few years, and you’re looking to diversify without taking a huge tax hit. Identifying positions that may have lost value in the recent markets gives you the opportunity to sell out of positions that have significant gains. If done correctly, you could greatly reduce your total taxes paid while also rebalancing your portfolio to an allocation more suited toward your risk tolerance and financial goals.

Any Restrictions?

Beware of the wash sales rule. It states that you or your spouse cannot purchase an identical or substantially similar investment within 30 days of the sale, if you want to claim the loss.

For example: If you’re confident about a particular company’s long-term performance but they’re down right now, you might want to sell your investment to claim a loss and then repurchase it because you expect it to rebound. Here’s where the rule comes in to play: You have to wait until Day 31 (or later) to buy back your position. If you don’t, you cannot claim the loss, therefore losing the advantage of tax-loss harvesting. In addition, your purchase could have a negative effect on your new investment’s cost basis.

The other important factor to consider when you’re wondering whether to employ this strategy: whether the tax benefits are worth the cost of trading. A financial advisor or fiduciary can help you make that analysis.

Are there other opportunities to employ this approach?

Don’t restrict tax-loss harvesting to downturns – or at the end of year, a common tactic. (At the end of the year, most people will identify the same investments or stocks to sell, so you might be selling lower than you need to.) Instead, consider tax-loss harvesting through the year, with the help of a certified professional.

Roth Conversions

Converting your investments to a Roth account can be a powerful tool in your retirement planning arsenal – especially during a market downturn.

Unlike a traditional IRA or 401(k), with a Roth account, taxes are paid before your money is invested, which means that not only do Roth accounts grow tax-free, but they also allow tax-free withdrawals during retirement.

A Roth Conversion occurs when an investor takes money from their pre-taxed retirement account, pays the taxes on that amount in the current year, and then redirects those funds back into a Roth IRA. Currently, there are no age or income limitations that prohibit this strategy.

Who stands to benefit the most from this strategy?

Investors often opt for Roth conversions when:

  • They want to control the amount of taxes they pay in retirement.
  • They believe the taxes they pay will be higher in the future, often due to a change in income and/or tax rate.
  • They want to minimize the taxes their children or heirs pay on unused IRA balances.

An Example of This Strategy in Action

Roth conversion strategies are not new to financial planning, but there is an added benefit of converting while the market is down.

Let’s say two brothers, Niles and Fraser both had traditional IRAs of $250,000 at the start of the year. When the market fell, their investment accounts both decreased by 20% leaving them with $200,000.

Niles, ever the opportunist and believing his investments would eventually rebound, converted his entire balance. At a 24% effective tax rate, which included both federal and state taxes, Niles paid $48,000 to cover his tax liability, which he pulled from an outside bank account.

Fraser, on the other hand, left his accounts as they were.

Over the next 15 years, the markets rallied and the brothers approached retirement, pleased that both of their accounts had now grown to $550,000 a piece, given an average 7% compounded return.

Assuming that both of them remained in the same 24% effective tax rate, Fraser would have to pay $132,000 in taxes, leaving him $418,000. Niles, on the other hand, already paid the taxes on his investments – to the tune of $48,000 – because of his Roth conversion and can now enjoy the entire $550,000 without paying a dime more in taxes.

Which would you rather be taxed on: the seed or the crop? To be sure, the crop is never guaranteed, but that single decision could be the difference in thousands of dollars in taxes paid over the course of your life or your beneficiary’s.

Are there other opportunities to employ this approach?

There are many other factors that can play into whether a Roth conversion is a good idea. Future cash flow needs, time left before applying for Medicare, or whether you have other non-deductible IRAs are just a few of the many factors that can affect the effectiveness of a Roth conversion as it relates to your overall financial plan.

The current market conditions in combination with changes made by the SECURE and CARES Acts could help you save thousands in retirement.

Talk to your financial advisor about whether either – or both – of these strategies is in line with your long-term goals.

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