It’s not fun to watch your portfolio decrease in value, but there is a way to make lemonade out of lemons! Consider these strategic moves to reduce your taxes, potentially increase your nest egg, and make this bitter pill easier to swallow.
It’s Harvest Time
Tax-loss harvesting time! When you sell an investment for less than you paid for it, you are harvesting, or realizing a loss that can offset current or future capital gains. Even if you have no realized capital gains to offset, the loss can be used to reduce current ordinary taxable income by up to $3,000. Any remaining capital loss can be used in future tax years.
Once sold, the proceeds can be used to purchase a similar investment so that you stay invested and reap the benefits of future market appreciation. Buyer beware! If you purchase the same security within 30 days, you will lose the tax benefit.
Retirement Contributions on Sale
If you are still working and contributing to your retirement plan, when the market is down, you are buying investments on sale. Each dollar you invest while the market is down is purchasing more shares of a security or units of a mutual fund than when the market was higher. As a result, your retirement account has the potential for more tax-deferred growth (tax-free with a Roth) when the market recovers.
You can still make 2015 contributions to an IRA or a Roth IRA until April 15, 2016. If cash flow allows, you should consider making 2016 contributions now as well and get the tax-deferred or tax-free accumulation started.
A market downturn can be the perfect time to convert money to a Roth IRA. When tax-deferred retirement accounts are converted to a Roth IRA, you will pay tax on any untaxed dollars in the year of the conversion. Using this strategy when the market is down allows you to convert with less taxes due, i.e. it’s cheaper to convert! And, once in the Roth IRA, all investment earnings and growth are tax-free when distributed.
Roth conversions are available to anyone regardless of income level. Existing Traditional IRAs or inactive employer retirement plans can be converted to a Roth IRA. SIMPLE IRAs can also be converted if the plan has been in existence for at least two years. Any amount of an eligible account, partial or total, can be converted.
Obviously, a Roth IRA is a great vehicle for tax-advantaged savings. When converting eligible assets to a Roth IRA during a down market, you are almost double-dipping the tax benefits. You are paying less in taxes on the assets converted and you have more potential for tax-free growth. It’s a win-win. Unless, it isn’t…
What? The Market Went Down Again!
So, your timing wasn’t perfect (no one’s is) and the investments you converted to a Roth IRA went down in value again! Now you are thinking that you might have to pay more in taxes than you should have. Not so. You have until October of the following tax year to "re-characterize" or "undo" the Roth conversion. Basically, you get a "do-over."
For example, if you converted assets in 2015 and the value went down, you have until October 17, 2016 to re-characterize your conversion. This means you return the same securities or mutual fund units to your retirement account from the Roth IRA. Then, you can move the same or different investments back to the Roth IRA (convert again) and pay the conversion income tax on the lower market value.
Save More for College
As you are aware, college tuition is expensive. The best investment vehicle, if you are saving over a significant period of time to send a child or grandchild to college, is the 529 Savings Plan. The 529 Plan distributes dollars tax-free for "qualified expenses."
Moreover, if you are an Indiana tax-payer and contribute to an Indiana 529 CollegeChoice Savings Plan, you receive a state tax credit equal to 20 percent of your contribution to the plan, up to a maximum credit of $1,000. Tax-free growth and a $1,000 state tax credit is already a significant tax savings. When you add the fact that you could be buying more units of a mutual fund with those dollars, you will have a greater bump in the account’s value when the market rebounds.
No one likes to watch their hard earned savings going down, but opportunities exist that allow you to make the best of a not-so-good situation. Take a deep breath and start reviewing the strategies that might work best for you. Then have a nice, tall glass of lemonade. It can be refreshing even in the winter.
This article was contributed by Meredith Carbrey, CFP, a Wealth Advisor at Bedel Financial Consulting, Inc.
Elaine E. Bedel, CFP, is CEO and president of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine’s book, "Advice You Never Asked For… But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at email@example.com.