Up 500, down 600, up 800. Over the past six weeks, the stock market notched some of its broadest swings in recent memory. It’s clear what a whipsawing Wall Street will do to returns and losses, but how can stockholders wring tax savings out of the ups and downs?
“Volatility can certainly drive investors to do something bad for their financial health,” said Dean Mioli, director of investment planning at Independent Advisor Solutions by SEI in Oaks, Pa. “For instance, selling out of equities last December 24 and sitting in cash. Those investors missed out on the stock market rebound that has taken place since then. Volatility can prey on one’s nerves but can also present opportunities to rebalance asset allocation.”
One big mistake in a volatile market? “Buying back into a dropping investment before it’s hit bottom,” said Brian Stoner, a CPA in Burbank, Calif. “Waiting for a stock or fund to start an uptrend before buying it will give you a better chance to actually buy it near the bottom, which can generate more profits longer term. More taxes, too.”
Tax-loss harvesting is one way to strategically use volatility. “The idea is to identify and sell investments that have decreased in value and replace them with a similar but not the same security,” Mioli said. “For federal income tax purposes, the capital loss generated doesn’t expire and if not used in the current tax year can be carried forward.”
“This generates a tax loss, but the taxpayer is still invested in the market,” added Kathleen A. Buchs, a CPA at MAI Capital in Cleveland. “Another option is to wait 30 days and reinvest in the same stock. This makes sense especially if the stock is expected to continue decreasing in value.” Reinvesting in the same stock in less than 30 days means the tax loss is disallowed due to wash sale rules.
“Harvesting works best when the taxpayer has capital gains to offset the losses, since capital losses in excess of capital gains are limited to $3,000 per year,” she said.
“We tend to focus heavily on this issue after Thanksgiving," said Jack Oujo, a CPA/CFP in Wall, N.J. "Every account gets reviewed.”
Oujo also likes a major Roth conversion during volatility. “We had many clients convert to a Roth during the turmoil in 2008,” he said.
When converting a traditional IRA to a Roth, the high-net-worth taxpayer pays ordinary income tax rates on the value of the account. “Once converted, those assets grow tax-free,” Buchs said. “If left in a traditional IRA, those assets are taxable on distribution. Converting during a downturn will yield a lower tax bill than if the same conversion occurred during an up market.”
The domestic equity market, measured by the S&P 500, rose about 200% over the past 10 years as of the end of July, according to Mioli. “One way to lock in those long gains and not pay tax is to donate appreciated securities to a donor-advised fund,” he said. “The investor will receive a deduction for the fair market value of the securities donated. Once inside the DAF, the donated securities are generally sold and invested in [a] portfolio model without a tax bill back to the donor.”
Oujo noted that client can move the appreciated stock to the donor-advised fund, and the fund makes a check to the charity in the name of the client. “This will help the client minimize a capital gain," he said. "A charitable remainder trust in conjunction with a wealth replacement trust is a strategy we’ve used when the gains are in excess of $1 million.”