Instead of passively waiting for a market rally, you can take action and avoid investing apathy with retirement planning and tax tactics.
Financial advisors say Roth IRA investing is "on sale" this year and will set you up for tax-free gains in the future. And they say tax-loss "harvesting" will enable investors to reinvest while reaping rewards.
Who knew taxes could ever be a bright spot? But investors beware: Tax strategies always require careful study of the IRS rules.
"Market downturns create favorable tax opportunities," said Anthony Watson, founder and president of Thrive Retirement Specialists in Dearborn, Mich.
Retirement Planning With Roth IRAs
Roth IRAs allow after-tax contributions to grow over time without a tax on withdrawal. Traditional IRAs allow you to sock away money pretax, but then you must pay taxes on the growth of the IRA when you withdraw the money. However, when you convert money from a regular IRA to a Roth IRA "you recognize the amount you're converting as income and pay tax on that money," said Watson. If your income is low this year, thus your tax rate is low, now may be the time to strike.
Why? Because your IRA investments have likely dropped in value from where they were at the peak of the market. So you'll pay less right now to convert those investments to a Roth IRA. "You're not only transferring the conversion amount to a forever tax-free account, but also the future potential growth on those conversion dollars will be tax free," said Watson.
Plus, tax rates right now are "historically low," said Scott Butler, a retirement income planner with Klauenberg Retirement Solutions in Laurel, Md. "We're likely to see tax rates go back up in 2025." Again, that makes doing a conversion now wise.
Beware of IRS rules: But that doesn't mean you should convert all of your IRA to a Roth IRA. For your retirement planning, it may make sense to do just part of it. If you're already retired and on Medicare or taking Social Security, you'll need to consider the tax impact the conversion income will have on those benefits. Medicare premiums are set based on income and a conversion could raise your premium. And pushing up your income with a conversion may also increase "how much of your social security is taxed at your tax rate," said Butler.
Tax Harvest Time
Another downturn strategy is to sell index holdings, taking capital losses for tax write-offs, then reinvesting in funds with similar risk profiles. "Thus, the investment goes from one broad-based index to another," said Watson. He's doing this for some clients using ETFs, which often trade with no commissions today.
The loss taken on the sell enables married couples to write off up to $3,000 this year ($1,500 for an individual), and potentially carry forward a loss for the future.
Harvesting also enables retirees to rebalance some of their portfolio and gain a tax write-off, says Watson. "When you near retirement, you want to start de-risking the portfolio," he said. So a prospective retiree may want to get out of an individual stock or a higher-risk fund. "Thus we can reposition the taxable portfolio," said Watson, plus reap a tax deduction.
Beware of IRS rules. The IRS does not allow harvested losses that violate its "wash sale rule." That means you can't take a tax loss from selling stock or fund shares in a taxable account if you quickly sell and buy "substantially identical securities" within 30 days.
To avoid this restriction and a potential audit, buy, for example, "an index fund that follows a slightly different index," said Watson. So, you could sell an index fund like Vanguard Total Stock Market Index ETF, which tracks the CRSP U.S. Total Market Index at perhaps a loss. You could then purchase Vanguard's S&P 500 ETF, which invests in stocks in the S&P 500 index. These two funds are not substantially identical, yet they have similar risk profiles.
"We look at tax harvesting every year," said Butler. "But this is a more advantageous time to consider it because asset values are down."
ETFs With Buffers
ETFs with buffers are another tool some investors might consider in these volatile times, says Butler. The FT Cboe Vest U.S. Equity Buffer ETF is one example. "It has a 10% buffer off of the S&P index," said Butler. "The ETF uses option spreads … so when the market goes down those options will take off some of that loss that you would have had otherwise."
ETFs never promise no losses. But buffered ones will absorb a portion of losses, say 8%, 10% or more. The price? You'll need to give up a portion of the upside if the market rallies.
Butler says these funds are helpful for "people who would let their emotions take over if an account goes down a lot."
And they're a tool for timing investments to track a retiree's or other investor's needs. "Anyone who is going to need the money in a short period of time, for say a house investment, you wouldn't want to take the same risk for that money" as he or she would on money that won't be needed a decade or more, said Butler.
He added: "Timing risk is something that retirees don't necessarily think about as much as they should." He helps his clients do retirement plans by segmenting assets for when they're going to need the money.
"The right investment for money you'll need five years from now isn't the same as for 20 years for now," he said.
