There's still time for financial advisors to soothe some of the sting investors have suffered from this year's market beatdown.
While monitoring a portfolio for opportunities to reduce tax bills is increasingly a year-round exercise, the annual ritual of ramping up scrutiny in the months before January is in full swing. With stocks down roughly 17% as of mid-November and economic uncertainty leading many advisors to believe recession is not an if, but a when, certain workhorse strategies now have a twist. Here's what financial planners can be doing right now.
From sow's ear to silk purse
Many investors have losses in their taxable retirement portfolios on lagging stocks, bonds, and mutual, index and exchange-traded funds. So it's time to use the Internal Revenue Code to make a refreshing drink out of sour citrus: U.S. tax law allows investors to offset profits with losses, a move that can cancel out a capital gains tax bill when both sides are matched.
If the losses exceed gains, an investor can use what's left to reduce up to $3,000 of ordinary income a year and carry remaining amounts forward to reduce taxes in the future.
With tax-loss harvesting, investors have to watch out for the
On the one hand, taking losses only makes sense if you have profits, and this year's broad market losses means that there may not be much for ordinary investors to offset.
"Taxpayers probably don't have the amount of capital gains in 2022 like they did in 2021, so harvesting losses may not make a whole lot of sense if there's really no gains to offset," said Elliott Brack, the managing director of tax services at Manhattan West, an investment firm in Los Angeles.
On the other hand, for investors with portfolios that have grown overly concentrated in a single stock, it makes sense to reduce the holding by taking some gains. Concentrated positions tend to be in appreciated securities, said Barbara Bilello, a partner and wealth advisor at RegentAtlantic Capital in Morristown, New Jersey, who recommends selling a position when it comprises more than 5% of a portfolio and soaking up the gains by dumping loss-making securities.
Despite its status as a go-to strategy, the benefits of tax-loss harvesting are hotly debated by academics and wealth managers.
Aperio, which is owned by BlackRock and caters to affluent clients,
In its automated form, daily loss harvesting is marketed as a profit booster by providers of low-cost exchange-traded funds and direct index portfolios geared to custom benchmarks. But as the strategy makes its way into the fiber of scores of investment portfolios, it can make a nest egg less diverse and more exposed to losses.
A study last July by Roni Israelov, the president and chief investment officer of NDVR, an investment advisory firm in Boston, and Jason Lu, a research economist in the economic modeling division of the International Monetary Fund,
The recent turmoil on Wall Street may put that finding to the test. By the end of this year, an ordinary investor who has endured losses in a mutual fund may find himself socked with capital gains distributions if he holds the funds in a taxable account, such as a brokerage account. That's because when an investor pulls out of a mutual fund, the fund has to sell appreciated shares to fund the redemptions, with the sales generating taxes on the profits. CapGainsValet, a website that
Staggering stock sales over the end of this year and January 2023 to take advantage of the fact that tax bills are calculated on a calendar-year basis can delay a check to Uncle Sam by more than a year. Lance Sherry, a wealth advisor at Kovitz Investment Group Partners in Chicago, said that for some clients, he sells some securities for a profit in the last days of December and again in the first week of January.
"It's only five business days, but from a tax purpose, we're able to defer the payment of taxes on half of the gains by 15 months," he said. "We're not really changing our investment approach or strategy very much, but we're delaying the taxes" due in April.
Roths on sale
Wealth advisors have long been big fans of converting a traditional individual retirement account or employer-sponsored 401(k) plan to a
Pay the tax bill upfront on the converted amount, then watch the pot appreciate, with no ordinary tax due on withdrawals once you've held it for at least five years and are at least 59 ½ years old.
But the big perk this year comes from a surprising place: the depressed stock market. Just as the value of a retirement plan's assets have fallen, so will the tax bills that come due — by the tax filing deadline of the next year — when it's converted.
Making the switch to a Roth now, when stock, bond and fund prices are lower, means a smaller tax hit along with a greater chance for those assets, and future tax-free withdrawals, to swell in value.
As Paul Saganey, the founder and president of Integrated Partners in Waltham, Massachusetts, put it, "Roth conversions right now are on sale."
Another benefit of converting now: Unlike with direct contributions to Roth plans, there's no limit on the amount that can be converted. So far more than the 2022 limit of
This year, married couples making
A client can't put $2 million into a Roth. But he can convert a $2 million IRA to its tax-free cousin, sidestepping the income limits of a direct contribution.
That "backdoor" strategy becomes even more lucrative when it involves a 401(k) plan.
The SECURE Act is unclear about whether some inherited retirement accounts have to be emptied out in 10 years or five.
"Essentially, the market has eliminated 25% of most people's portfolios," said Kovitz's Sherry. "If you were to do a Roth conversion, as long as you still have conviction in the underlying securities and conviction that the market as a whole will recover over time, you're essentially being able to do it at a discount."
But he added that advisors have to be careful not to accidentally nudge a client into a higher tax bracket, as the converted amount counts as taxable income.
For small business owners whose companies posted net operating losses during the pandemic, a conversion can be extra lucrative, as the tax bill can be offset by those losses. Taxpayers can
"You want to absorb that taxable income from the Roth conversion against those losses," Brack said.
He doesn't recommend conversions for older individuals because of the time — generally 10 to 12 years, in his estimate — that it takes to break even on paying taxes upfront.
Make inflation work for you
With consumer price increases running the highest in four decades, the IRS substantially increased the income levels at which a specific tax rate kicks in for 2023. That means some people who are just barely in a current bracket
In general, said Laura Mandel, chief fiduciary officer of The Northern Trust Co., an investment and wealth management firm, a conversion has traditionally been viewed as advantageous if your future tax bracket is going to be higher, perhaps due to increased earnings. But because depressed markets have driven down asset values, a conversion this year can also be worthwhile for people who don't expect their income to rise in the future.
"Essentially, the market has eliminated 25% of most people's portfolios," said Kovitz's Sherry. "If The agency also boosted the amount of money a taxpayer can pass to heirs tax-free during their lifetime. This year, a person can give away up to $16,000 each to as many people as she likes without the gifts cutting into her lifetime exemption of just over $12 million, the level at which the 40% estate tax kicks in. Next year, the gift exclusion rises to $17,000 and the lifetime gift and estate tax exemption to just over $12.9 million (exemption levels are roughly double for married couples).
With asset values depressed, that means any largesse passed on now has more room for upside when markets and asset prices bounce back in the future. Assume that you give your children dollars that go into a trust which then invests the money. Do that before year's end and in early January, Mandel said, "so that beneficiaries get the run up in assets."
