As we enter the fourth quarter of 2015, it seems likely that the US stock market will experience its first loss in several years. While this decline is disappointing, there may be a silver lining in the form of tax loss harvesting.
Most diligent accountants will remind their clients of end of the year tax savings strategies that usually focus on pre-payment of deductible expenses and maximizing contributions to various types of benefit plans. While my main role for clients is their investment advisor, my responsibilities also include effective and proactive managing of the tax liability. This narrative will discuss strategies to be implemented to investment portfolios that may produce significant tax benefits.
As many of you are aware, I recently re-positioned investments in the energy sector in your portfolios. In most cases, this liquidation resulted in a realized loss. While there is no tax benefit for a retirement plan since losses are not deductible, the loss in an after tax account can and should be used to offset gains generated from other investments. As we approach the end of the year, I may take additional steps to benefit from tax losses in under-performing asset classes.
During my regular reviews with clients, I ask and learn of unused and potentially tax deductible losses. Among these items are out-of-pocket medical expenses such as nursing home costs and net operating losses from a business. Unfortunately, in some cases, the client has insufficient income to benefit from these losses.
If the taxpayer owns an IRA, an effective strategy to utilize these losses is to convert the IRA to a Roth IRA. While income taxes are payable on the converted amount, they may be offset by applying these unused losses. The result may be the creation of a tax free retirement account without the necessity of writing a check to pay the taxes.
Over the course of the year, many taxpayers may have converted their IRA to a Roth IRA. As previously noted, this strategy results in the payment of income taxes on the converted amount. Due to the stock market correction this year, the value of many of these accounts may have declined from the conversion date. A prudent tax strategy to take advantage of this drop in value would be to convert or recharacterize the Roth IRA back to its original traditional IRA. The IRS allows recharacterization of Roth IRA conversions to traditional IRAs until October 15th of the year following the conversion. As long as you wait for the later of 30 days or the year following the conversion, you may then reconvert the traditional IRA to a Roth IRA. The benefit is that the value of the newly converted account may have decreased resulting in a reduced income tax bill.
Most taxpayers are aware of the $14,000 annual gift tax exclusion. Over the years, I have often advised clients to direct gifts into 529 accounts for their children or grandchildren. But a way to benefit all family members is to gift highly appreciated assets such as stocks and mutual funds. While the cost basis remains the same when the asset is sold, the beneficiary of this gift is often subject to a lower capital gains rate than the donor or may even avoid taxes altogether if they are in the 10% or 15% income tax bracket.
During the course of any year, portfolio managers will sell securities for a gain that have been held for a number of years. While the security may have been sold earlier in the year, the subsequent distribution of these now realized gains to shareholders is generally deferred until the end of the year. Prior to the distribution, the fund's Net Asset Value (NAV) will reflect the value of this pending distribution. When the distribution is finally made, the NAV declines by that amount. If an investor in a taxable account bought the mutual fund just prior to the distribution of the gain, they will be subject to taxes on the gain even though the account value did not increase. This mistake is easily avoided by waiting until after the distribution but unfortunately, many unknowing investors do not pay the careful attention necessary to avoid this costly mistake.
Clifford L. Caplan, CFP®, AIF®
In the News: In an article titled "Why Media Stocks Are Struggling" that appeared in US News & World Report on August 12th, I was quoted about possible future returns in media stocks in the highly competitive environment that has resulted from fledgling streaming services such as Hulu and Netflix.
Neponset Valley Financial Partners does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.