If you lose 10 percent, you’ll need to gain 11 percent to recover, for example. Once those losses reach 50 percent, you’ll need a 100 percent gain to get you back to square one. While there’s considerable risk in investing in the market, there can also be great rewards (why else would anyone do it).
Rather than panic when the market fluctuates, you should focus on things you can control, like how to minimize taxes. Taxes and fees may not have been your first consideration when making portfolio management and investment decisions. However, they can have a significant impact on returns and give you a sense of control during uncertain times.
Now more than ever, it’s essential to look at the elements you can control to minimize your losses and make it to the other side in solid financial standing. Writer, motivational speaker, and businessman Stephen Covey calls this tactic operating within your “Circle of Influence.”
Tax Reduction Strategies to Use During a Crisis
You may be wondering, “What should I do with my investments now?” Even when the market is doing well, it’s good to review the tax implications of your investment decisions.There are a lot of factors affecting investment decisions in portfolio management, especially when it comes to taxes. But if you want to know how to minimize taxes, focus on what’s in your control.
Place Rebalancing Trades inside a Retirement Account
Whenever you shift stocks or bonds back to their intended targets after a market movement, pay attention to whether you’re trading inside a taxable or retirement account. This can make a significant difference in your tax reduction strategies.Your financial plan may have you investing 70 percent in stocks and 30 percent in bonds, for example. But the current market decline may mean your allocation is now closer to 60 percent stocks and 40 percent bonds. To keep your risk level consistent, you will need to rebalance. In this case, that means you would sell bonds and buy stocks.
If those bonds’ values have appreciated since you first purchased them, then you would incur a capital gain upon selling. If you place these trades inside a taxable account, you must report that gain on the current year’s tax return. However, if you can conduct the rebalancing trades inside a retirement account—an IRA, 401(k), or Roth IRA—you would avoid a tax bill.
Try Tax-loss Harvesting
In the above strategy, trading inside a retirement account was ideal. But to take advantage of tax-loss harvesting, trades would need to be placed inside a taxable account.Here’s how it works: Say a fund you’ve invested in has had a sizable loss. You could consider selling that position and buying a similar fund the same day. The buying and selling the same day allows you to capture a loss—which can be used to offset future gains—while keeping your overall asset allocation intact.
Consider Roth Conversions
If you’re in a lower tax bracket now than you will be later, you could make Roth contributions or conversions. When the market is at a lower value—like now—this is a particularly advantageous portfolio management and investment decision.When you do a Roth conversion, you take money from an IRA (which has never been taxed) and move it into a Roth account. The value of your assets is the amount you’ll report as ordinary income on the current year’s tax return. However, that amount is the value of your assets on the day you make the conversion.
Contribute to Retirement
You may be in a higher tax bracket now than you expect to be when you plan to withdraw money from your retirement accounts. If so, making contributions to a traditional IRA or 401(k) can be a significant tax strategy. When you make this portfolio decision, you get the tax deduction now.For example, the maximum contribution for a traditional IRA is $6,000 if you’re under 50 years old. For those over 50, it’s $7,000. If you contribute that in 2022, you can deduct $6,000 (or $7,000) from your income on your 2022 tax return. Whenever you do take money out of the IRA later, those distributions will be taxable at ordinary income rates.
On the other hand, you may be in a lower tax bracket now than you expect to be in later. If so, contributions to a Roth IRA may be a better portfolio decision when thinking about how to minimize taxes. Although you’ll miss out on that $6,000 deduction on your 2022 tax return, those funds will grow tax-free. When you withdraw money from the Roth IRA during your retirement, you can also do so tax-free.
No matter what account you contribute to, it’s a good idea to take this step when the market is down. At the lower value, you’re able to purchase more shares with your dollars.
Practice Charitable Gifting
If you’re in a high-income tax bracket, making a larger charitable contribution than usual can net you a tax deduction. Donor-Advised Funds, or DAFs, are a great way to accomplish this. DAFs allow you to contribute several years’ worth of charitable gifts at once. Although the money can be distributed to charity over many years, you receive the tax deduction the year you add to the account.Add to a 529 Plan
Another tax reduction strategy you can leverage right now is to contribute to a 529 plan. A 529 plan is a savings account for education-related expenses, and funds contributed to the account grow tax-free.Portfolio Decisions: A Tale of Two Investors
How much of a difference can these tactics make when it comes to minimizing taxes and protecting your portfolio? To answer that question, let’s compare two investors: one who plans their investments around tax implications and one who doesn’t.John’s Investment Strategy
John has good intentions to manage his money, but his career and family often take up most of his time. Although he invested some money several years ago—adhering to a 70/30 allocation for stocks and bonds—he hasn’t done much with it since.Now, his allocation has shifted to 85/15. As a result, his portfolio is more aggressive than he intended, making him more susceptible to losses during market declines. He’s also neglected his Roth IRA and has amassed a small balance since he has forgotten to make annual contributions.
Although John does make charitable gifts, he doesn’t contribute enough to itemize his deductions—so he receives no tax benefit. After the downturn, John could have taken advantage of tax-loss harvesting to offset future gains. However, he didn’t pay enough attention to his finances to even know this was an option.
Jenny’s Investment Strategy
In comparison, Jenny realized she didn’t have the time or desire to deal with her investments on her own. She works with a financial advisor to make portfolio management and investment decisions. She and her advisor have kept her 70/30 allocation intact through continual rebalancing over the years.Now that the market is in a downturn, 30 percent of Jenny’s portfolio remains in safer assets (e.g., bonds). So, she’s less susceptible to market volatility. She also has made annual Roth contributions that have compounded over the years to a great size.
During the downturn, some of Jenny’s funds have lost value. Through tax-loss harvesting, however, she captured $50,000 of losses. She can now use that to offset gains for several years on her tax returns. Jenny also has been “clumping’ her charitable donations, which enables her to receive a tax benefit every few years. In addition, she has been contributing to a 529 plan for her kid’s education. This has earned her a tax deduction now, and the money in the account grows tax-free.
When you think about how to handle your investments during a downturn, take a page from Jenny’s book. While taxes won’t be the sole driver of your portfolio management and investment decisions, they should be an important consideration. Although you can’t control the stock market, there are plenty of proactive planning and tax reduction strategies you can take advantage of—in any market climate.
© 2022 The Epoch Times. The Epoch Times does not provide investment advice. All rights reserved.
