4 tax opportunities created by market downturn, stimulus

I’m pretty sure every financial advisor I know would prefer bull markets to bear markets, but smart advisors view bear markets with the same eye for opportunity as they view bull markets. Here are four techniques that are especially applicable to this bear market, including one created by the Coronavirus Aid, Relief and Economic Security (CARES) Act.

1. Tax loss harvesting

One highly valuable opportunity in down markets is tax loss harvesting. Tax loss harvesting provides a couple of key advantages.

First, the loss from the sales can be used to offset future gains, and a small portion of the loss ($1,500 for single, married filing separately or $3,000 for married filing jointly) of the loss can offset ordinary income.

For example, if I were single and I harvest $100,000 of losses this year and only end up recognizing $10,000 of capital gains, I will pay no tax on the recognized capital gains, and I’ll get a $1,500 deduction against ordinary income. I can carry over the remaining $88,500 against future years’ capital gains.

Tax-loss harvesting can also help get a “stuck position” unstuck. If an advisor has clients who have accumulated significant gains in a single position, such that it is now outsize compared to the rest of the portfolio, but they were hesitant to trim back due to the tax implications, offsetting the gains with losses harvested in other parts of the portfolio can help bring the overall portfolio into line with the client’s goals, without incurring a big tax bill.

Since capital gains can create a variety of painful interactions with Social Security benefits, ordinary income tax and net investment income tax, harvesting losses can have an outsize positive impact on the client’s overall financial plan.

There are a few cautions to be mindful of when executing a tax loss harvesting strategy. The last thing an advisor would want to do is sell desirable holdings into a market trough and leave the proceeds in cash, so evaluating the tax impact against the impact on the portfolio’s overall strategy is important.

The advisor should first identify alternate portfolio holdings to purchase, after the sale of the original holdings, that meet the risk/return profile established with the client. In the process of selecting alternate holdings, wash sale rules must be considered.

If the same or “substantially identical” positions are repurchased by the client (not necessarily in the same account), within the following 30-day period, then the loss is disregarded for tax purposes. In order to achieve the desired tax outcome, advisors need to be mindful of their replacement holdings, ensuring they are not substantially identical to the holdings sold.

Tax loss harvesting is generally a strategy used only in nonqualified accounts, but you’ll need to be mindful also of the interaction with other client accounts. You could accidentally violate wash sale rules by harvesting a tax loss in the nonqualified account, then completing a rebalance in an IRA or Roth IRA that causes the client to repurchase the same security in the IRA or Roth that they just sold in the nonqualified account.

In order to mitigate this concern, consider completing any rebalances for clients who are also doing tax loss harvesting using the alternate portfolios, managing the new purchases as a separate “sleeve,” or postponing the rebalance until the wash sale period expires. Each technique has positives and negatives.

2. Roth conversions

A second technique to be evaluated during times of market stress is Roth conversions. Hopefully this is a regularly used technique in your retirement planning practice. One of the most common problems for retirement plans is an overabundance of IRA money that causes future required minimum distributions (RMDs) to be greater than the client’s need for spending, subjecting each dollar of excess RMD to the client’s highest marginal tax rate.

Roth conversions are a technique that allows advisors to help “smooth” the client’s tax bracket over the client’s lifetime, reducing the overall lifetime tax liability. That said, Roth conversions take on a special importance in down markets.

If a client’s IRA is likely to be overfunded, even in the presence of a correction or bear market, then pushing funds from the IRA into the Roth and paying taxes now, particularly at the current historically low tax rates, allows any recovery to occur tax-free and to be passed to beneficiaries at the client’s death tax-free as well.

Second, in normal times, most advisors wait until the end of the year to determine Roth conversion amounts in order to have a good grasp on any interactions with capital gains (such as net investment income tax, Medicare premium surcharges, phaseouts of deductions, or capital gains bracket bumps from 0-15% or from 15-20%) that are realized through the year.

You may be able to accelerate those conversions to earlier in the year, knowing they will have harvested losses likely to offset at least the amount of gains the client may accumulate through the balance of the year.

3. Skip the RMD (CARES Act)

The recently passed Coronavirus Aid, Relief and Economic Security (CARES) Act allows IRA owners who would otherwise be subject to required minimum distributions to forego making those distributions in 2020.

The option to skip the RMD is not just applicable to “regular” RMDs, but also to initial RMDs for people who turned 70 ½ in 2019 but decided to forego their initial RMD until tax year 2020, and also to inherited IRAs. There are specific opportunities to consider with each.

The initial RMD would need to have been taken by April 1, while the regular RMD for 2020 would have needed to be taken by Dec. 31. If the initial RMD was taken within the last 60 days, it could be rolled over into an IRA as an indirect rollover, accomplishing the same result as skipping it.

People who have taken their initial RMD, but are out of the 60-day window, or had to take separate RMDs from multiple accounts won’t have the option to do the 60-day rollover due either to the timeline or to the “one rollover per year” rule, at least not for the totality of RMD amounts.

For those people, pay attention to the developing guidance and the client’s personal circumstances as they relate to the 3-year repayment option that was also part of the CARES act.

If the client was impacted by COVID-19 (specific rules apply here), the client can recontribute the amount withdrawn to the IRA and it will be treated as a loan, wiping out the tax consequences of the withdrawal.

The recontribution option is available for regular RMDs in addition to the initial RMD.

For clients who don’t need either their regular RMD or the RMD from an inherited IRA, consider doing a Roth conversion. For the traditional IRA, you could convert the entire RMD amount, or likely better, only the amount that keeps the client in a key tax bracket.

Although you can’t directly convert the inherited IRA RMD to a Roth, by not taking it, the client will have additional room in their current tax bracket, which may make a conversion from their own IRA more desirable.

4. Poor on paper

The prior techniques generally revolve around keeping the client’s tax bill relatively steady, but there is another alternative that sometimes makes sense — often referred to as “poor on paper.”

For clients who have nonqualified accounts and can live off the combination of Social Security and principal withdrawals, it may be possible to have an unusually low income year in 2020, which may qualify them for a variety of other benefits.

For some, this might mean relief from local property taxes on the primary residence. For others, it could mean qualifying for a health care subsidy under the Affordable Care Act.

Evaluating whether a year of “poor on paper” is better than smoothing out a client’s lifetime bracket will be a case-by-case situation.

Regardless of the techniques you employ in your practice, market declines should be about much more than simply reassuring clients and telling them to sit tight and wait for the market to recover. Instead, they should be viewed as opportunities to stick to your investment strategy, while looking for financial planning opportunities that only occur once every several years.

 

Joe Elsasser developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Joe later founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.

In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly affect cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk. In January 2019, Covisum launched Income InSight, an income planning tool.

Covisum powers some of the nation’s largest financial planning institutions and serves more than 20,000 financial advisors.