There is no question now: we are in bear market territory, and we will likely hover in this range for the next couple of months as our governments, health care systems and businesses learn to operate in the midst of coronavirus. Volatile markets can be difficult to endure, but there are actions you can take now to shore up financial portfolios and provide short- and long-term flexibility.
With the stock market down more than 20% from its high, consider converting traditional IRA money (all or a portion) to a Roth IRA. As a refresher, traditional IRAs are tax-deferred meaning you contribute pre-tax money now, but pay taxes when you make withdrawals, presumably in retirement when your tax bracket may be lower; Roth IRAs, on the other hand, are tax-free meaning you contribute after-tax money now, but never pay taxes on qualified withdrawals. When you convert traditional IRA assets to a Roth IRA, you pay the income taxes on the current fair market value now; we recommend paying taxes from a taxable account. Then any future growth is tax-free!
The value of your traditional IRA assets are likely down from where your account started the year, so your Roth conversion will result in less of a tax hit, and when the equity market recovers after you convert, then the resulting gains will be tax-free. So, if you own XYZ stock in a traditional IRA and it is down 30%, you pay taxes on that lower fair value when you convert. When it bounces back, the gain will be tax-free.
Another advantage: Do you have a have a darling stock that has been battered in this market chaos? You can transfer shares of securities from your traditional IRA to a Roth IRA in an in-kind transfer.
Roth conversions can be a powerful tool to tap into tax-free growth. If you believe that the current low income tax rates will not last, then doing a Roth conversion will allow you to lock in today's tax rates and benefit in the long-term by paying no taxes during retirement.
Tax loss harvesting
While drastic measures like completely liquidating your portfolio could hurt your long-term plans, getting rid of a few losing stocks could improve your tax picture for 2020. Selectively pruning assets that have fallen in value allows you to use these losses to offset capital gains from other appreciated assets you may have sold or will sell this year. This strategy only works in taxable investment accounts. Individual retirement accounts (401(k)s and IRAs) are not subject to taxation; therefore, you cannot use losses in these accounts to offset gains in taxable accounts. If you do not have any gains, you can use the loss to offset up to $3,000 ordinary income and any excess tax losses carry forward over your lifetime. Remember: once you have harvested the losses, we recommend reinvesting the cash to buy other investments to maintain your portfolio's allocation. Be mindful of the wash sale rule.
Putting cash to work
Panic and fear are driving the financial markets, which typically provides opportunities for long-term investors. Stock valuations have come down from the high levels seen last month, and as often happens, the market has indiscriminately pulled down even high quality stocks. If you have cash sitting on the sidelines (over and above 1-year liquidity needs), now might be the time to consider adding some risk to your portfolio. Unfortunately the markets never give us an all-clear signal, and we could see further pressure on the equities markets. Therefore we recommend slowly investing cash, and opportunistically picking up good long-term opportunities, while holding back some cash in case more opportunities arise.
Finally, it is almost certain that the number of cases in the United States will ramp exponentially over the next few weeks as the virus spreads and testing increases. So volatility will remain high. But we will move beyond this at some point and experience an economic recovery. While it is frustrating to hold steady, we have outlined a few actions you could take, but we encourage you to exercise discipline in these emotional and uncertain times.
As you can imagine, these three strategies require careful consideration of many tax, markets and execution nuances. If you are interested in one of these suggestions, please contact us and we are happy to advise on your personal circumstances.
Most importantly, let's look after our loved ones and communities. My very best wishes to you and yours as we all navigate this unusual time together.
This information is not intended to be a substitute for individualized tax advice. As always, we encourage you to include your CPA in tax-related decisions.
Your contributions will always be tax-free, but the gains could be subject to an early withdrawal penalty.
To make a qualified withdrawal and avoid a potential 10% early withdrawal penalty, you must be older than age 59.5 and the account must be at least 5 years old. There are exceptions to the early withdrawal penalty, such as a first-home purchase or college expenses.
A wash sale occurs when you sell a holding at a loss and purchase an asset that is substantially similar to it within 30 days before or after the sale. In this case, the IRS will not allow you to claim the loss on your tax return; instead the loss will increase the basis on the new asset.