|
Tax Strategies for a Depressed Stock Market
Nobody except hard-core short sellers can be very happy about the stock market's recent performance. That said, things have gotten somewhat better lately. We have a bit of additional good news to share with you the market decline has opened up some helpful tax-saving opportunities. When you think about it, reducing your tax bill is just as good as making money in the market. In fact, it's almost better because you won't owe any taxes on the extra dough you'll find in your pocket.
Here is our short list of tax-smart strategies that can work for you during and after periods of exceptionally lousy stock market conditions.
Revamp Your Investment Portfolio and Cut Taxes Too
With all the recent market turmoil, it's likely time to revamp and rebalance your portfolio. The silver lining in the bad market performance of late is that the tax cost of revamping your portfolio is not so bad. So, while it's not generally wise to let tax implications drive investment decisions, you should not ignore them either.
As you know, the current maximum federal income tax rate on long-term capital gains from selling stock and mutual fund shares held in taxable brokerage firm accounts is only 15%, which is pretty good by recent historical standards. However, 0% is even better, and 0% may be all you'll owe if you see this as a good time to revamp your taxable brokerage account's stock and equity mutual fund portfolio. Let's assume the revamping would involve selling some winners (current market value above what you paid), as well as some losers (shares currently worth less than what you paid). As long as the losses from the losers fully offset the gains from the winners, you'll owe nothing to the IRS as a result of your revamping efforts.
But why stop there? You can continue trimming unwanted loser shares until you've generated a $3,000 net capital loss for the year. You can then deduct that $3,000 loss against this year's income from other sources salary, self-employment income, interest, dividends, alimony received, and so on. If you are married and file separately from your spouse, the annual net capital loss deduction limit is only $1,500 versus the usual $3,000 limit. This tax-saving strategy of selling unwanted loser shares before year-end is what Wall Street types call "harvesting" losses (to put a positive spin on a negative thing).
Once again, why stop there? If your loss harvesting is more extensive, you can generate a net capital loss that is well above the annual deductible limit ($3,000 or $1,500). This can turn out to be a tax blessing, since you can use that "excess loss" to shelter later capital gains. In fact, the tax shelter provided by your excess loss gives you great investing flexibility. Why? Because you can use the excess loss to shelter short-term gains from sales later this year, or in future years, as well as long-term gains. (You can carry forward any excess loss remaining at the end of this year to 2010 and beyond until you have enough gains to use it up.)
More specifically, to the extent of your excess loss, you don't have to worry about holding onto profitable positions for over a year just to get better tax results. With your excess loss in hand, you can exit profitable positions anytime you want without triggering any federal income tax bill whatsoever (assuming your excess loss is big enough to provide all the shelter you need). Even better, that excess loss might wind up sheltering gains in future years when tax rates are higher. All in all, owning an excess loss is really quite liberating when you think about it the right way. (To be sure, selling losers to generate that excess loss may be psychologically painful, but the welcome feeling of liberation will set in almost immediately thereafter.)
Sell Winner Shares from Retirement Accounts; Sell Loser Shares from Taxable Accounts
If you happen to be one of the lucky ones who has profited from this year's market upticks, you may not have enough unwanted losers in your taxable brokerage firm account to fully offset gains from your taxable account. As you now adjust your portfolio by selling some winners, you may still be able to avoid or minimize the tax hit. Do this: try to sell winners mainly from your tax-advantaged retirement account (traditional or Roth IRA, 401(k), variable annuity account, and the like). Try to sell losers mainly from your taxable account. That way you can take some profits without necessarily paying the IRS for the privilege. In fact, if you can generate a net capital loss from taxable account sales, you can actually shelter up to $3,000 (or $1,500) worth of income from other sources, as explained earlier.
When Making Gifts: Give Away Winner Shares But Sell Loser Shares and Give Away the Cash
Say you want to make some gifts to favorite relatives (who may really be hurting financially) and/or charities (ditto). You can make gifts in conjunction with an overall revamping of your holdings of stocks and equity mutual fund shares held in taxable brokerage firm accounts. Here's how to get the best tax results from your generosity.
Gifts to Relatives. Don't give away loser shares (currently worth less than what you paid for them). Instead sell the shares, and take advantage of the resulting capital loss as explained earlier. Then, give the cash sales proceeds to the relative.
Do give away winner shares to relatives. Most likely, they will pay lower tax rates than you would pay if you sold the same shares. In fact, relatives who are in the 10% or 15% federal income tax brackets will generally pay a 0% federal tax rate on long-term gains from shares that were held for over a year before being sold. (For purposes of meeting the more-than-one-year rule for gifted shares, the recipient owners get to count your ownership period plus their ownership period, however brief.) Even if the shares are held for one year or less before being sold, your relative will probably pay a lower tax rate than you would (typically only 10% or 15%). However, beware of one thing before employing this give-away-winner-shares strategy. Gains recognized by a younger relative who is under age 24 may be taxed at his or her parent's higher rates under the so-called Kiddie Tax rules (contact us if you're concerned about this issue).
Gifts to Charities. It turns out the strategies for gifts to relatives work equally well for gifts to IRS-approved charities. So, sell loser shares and claim the resulting tax-saving capital loss on your return. Then, give the cash sales proceeds to the charity and claim the resulting charitable write-off (assuming you itemize deductions). As you can see, this idea results in a double tax benefit (tax-saving capital loss plus tax-saving charitable contribution deduction).
With winner shares, give them away to charity instead of giving cash. Here's why. For publicly traded shares that you've owned over a year, your charitable deduction equals the full current market value at the time of the gift. Plus, when you give winner shares away, you walk away from the related capital gains tax. This idea is another double tax-saver (you avoid capital gains tax on the winner shares, and you get a tax-saving charitable contribution write-off to boot). Because the charitable organization is tax-exempt, it can sell your donated shares without owing anything to the IRS. Truly, this is a win-win situation for everybody except the government.
Convert Your Traditional IRA into a Roth IRA
Here's the best scenario for this idea: your traditional IRA is (or was) loaded with equities and took a major beating during the stock market downturn. Thus, your account is now worth a lot less than it once was. Correspondingly, the tax hit from converting your traditional IRA into a Roth account right now would also be a lot less than before. Why? Because a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth account. While even the reduced current tax hit from converting is unwelcome, it may be a small price to pay for future tax savings. After the conversion, all the income and gains that accumulate in your Roth account, and all withdrawals, will be totally free of any federal taxes assuming you meet the tax-free withdrawal rules. In contrast, future withdrawals from a traditional IRA could be hit with tax rates that are much higher than today's rates.
Of course, conversion is not a no-brainer. You have to be satisfied that paying the up-front conversion tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher 2009 tax brackets, which would not be good. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth IRA investments, and so forth. To be eligible for a Roth conversion this year, your 2009 adjusted gross income cannot exceed $100,000. In 2010, the $100,000 restriction will go away unless Congress changes the deal. If the Roth conversion idea intrigues you, please contact us for a full analysis of all the relevant variables.
You now know about some tax-smart moves that can be especially helpful during and after a down stock market. Please contact us if you have questions or want more details about the ideas in this letter.
There are plenty of other tax issues to think about as well this year especially after all the recent tax law changes (with more probably on the way). We are always ready to talk with you about those things too.
|
