The recent market rout has stunned many investors. Even after this week’s rebound, the S&P 500 is more than 10% below its peak last May.
That makes it a good time to review tax strategies to help ease the pain, such as taking losses to offset future gains, or converting an individual retirement account to a Roth IRA when asset values—and thus taxes—are lower.
“At times of volatility, people should look for tax opportunities they don’t ordinarily think of,” says Suzanne Shier, chief tax strategist with Northern Trust Co. in Chicago.
Here are moves to consider:
Selling losers. Investors who sell losing positions held in taxable accounts receive capital losses they can use to offset capital gains on the sales of other assets, reducing future taxes on their winners. Although such losses can’t offset gains from sales in earlier years, such as 2015, they do carry forward indefinitely for future use. Investors can also deduct up to $3,000 of capital losses against ordinary income (such as wages) annually.
A variation of this move is to “harvest” losses from holdings that are worth less than the purchase price but that the investor still wants to own. Here the investor sells shares to book a loss and immediately repurchases a similar security so as not to miss out on a rebound. Investors can’t repurchase shares in the original investment for 30 days, or the benefit of the loss will be postponed.
Contributing to a retirement plan. Taxpayers’ annual contributions to IRAs, Roth IRAs, 401(k)s and Roth 401(k)s are capped at specific amounts. As a result, taxpayers who put money in when values are lower can reap tax-free growth when markets rebound—assuming they do.
Contributions to 2015 IRAs and Roth IRAs can be made up to this April’s tax-filing date.
Converting to a Roth IRA. Roth accounts are considered the gold standard of tax-favored retirement plans: Both asset growth and withdrawals are tax-free, and the owner doesn’t have to take required payouts starting at age 70½.
There also are other benefits, especially if the owner will owe state death duties or plans to leave the account to a younger heir. Experts don’t think Congress will erase Roth benefits for most taxpayers.
The law now allows all IRA owners to convert accounts to Roth IRAs—but income taxes are due on the switch. To minimize them, many people do partial conversions in years of lower or negative income, such as after retirement, during a break in employment, or if there are high nursing-home expenses. Converting to a Roth when asset values are down also can lower the tax bill.
What if markets drop further? Unusually, the law allows owners to reverse a Roth conversion up to the October tax-filing date of the year after the conversion. So taxpayers who convert this year have until Oct. 16, 2017 to undo it.
If you go this route, says IRA expert Ed Slott, a CPA who practices in Rockville Centre, N.Y., be sure to segregate the money in a dedicated Roth account until it is clear you won’t reverse the conversion. That will allow you to preserve benefits and avoid complexity, he says. After that, these funds can be mingled with other Roth assets.
Undoing a Roth conversion. Are values lower than when you did a Roth conversion last year? You have until Oct. 17, 2016 to reverse it and avoid paying more tax than necessary.
Taxpayers who want to “reconvert” such funds need to wait 30 days before converting them again, according to Mr. Slott. But IRA owners who have other IRA assets they haven’t converted can switch them immediately, he adds.
Exercising employee stock options. Workers with “nonqualified” options, the most common type, usually owe taxes on the difference between the options’ grant price and the shares’ current value when they exercise the options. A market decline often lowers this tax cost.
For example, if an option was granted at $30 and the share price rises to $45, the employee who exercises at that point will owe income and payroll taxes on $15. But if the stock drops to $35 and the worker exercises then, taxes are due on $5.
“A stock-market selloff can be a beautiful time to exercise options, especially for long-term investors,” says Eddie Adkins, a benefits specialist with Grant Thornton in Washington. If the shares are held for more than a year after exercise, the growth can be taxed at lower long-term capital-gains rates when they are eventually sold.
Making gifts of assets. For people who want to give assets to relatives or others, or to a trust, a market decline means the ability to transfer more for the same gift-tax cost, which could be zero.
For example, the law allows each taxpayer to make unlimited number of tax-free gifts of up to $14,000 a year, so long as there is only one gift per recipient. (Married couples are allowed to combine their gifts, so that one partner can make a $28,000 gift.)
So if a grandparent gives a grandchild shares worth $14,000 that have dropped in value, and they later rebound, the law doesn’t assess more gift tax.
The same principle applies, Northern’s Ms. Shier says, for taxpayers making gifts to Grantor-Retained Annuity Trusts and other irrevocable trusts. The combination of low current interest rates and a decline in value can enable transfers at lower tax cost.
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