Nobody likes a down market, but what a pullback can uncover is an opportunity to re-focus on what you can control. Implementing tax-efficient strategies while investing is a big one. Today we present a guest article looking more closely at the tax side of things by Nathan Wilding, Tax Accountant at Fox Peterson Entrepreneurial Accountants in Mesa, Arizona. At Sonmore Financial, we work closely with our clients’ CPAs and Accounting professionals to help maximize tax savings and help protect retirement income.
Here are five strategies to avoid/minimize your tax burden while investing in a down market.
1. Buy and Hold Investments
When it comes to your investments, a great practice for deferring taxes is to take the buy-and-hold approach. A big reason why is that taxes are not owed on investments like stocks, mutual funds, and real estate until that investment has been sold. So, buying an investment and holding on to it for years or decades defers any taxes on any gain/appreciation from that investment for that amount of time. So, if you wanted, you could defer taxes indefinitely from an investment by never selling.
This also allows for a better chance of growth as buying and holding over several years can generally earn more over time. This approach also helps alleviate the pain of a down market, with the knowledge that – over the long-term – the market can average out to a positive income depending on your investments.
2. Take Advantage of Long Term vs. Short Term Capital Gains Rates
There are two classifications of investments that are important to know for tax purposes: short-term capital gains and long-term capital gains. These two types of gains are taxed differently. Knowing these rules can save you in taxes if utilized correctly.
A short-term investment is an investment that has been owned for 1 year or less and a long-term investment is an investment that has been owned for more than 1 year. When a short-term investment is sold, the gain on that sale is taxed at ordinary tax rates. These are your standard tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37% depending on your level of total taxable income (as of 2022).
If you sold a long-term investment, your tax brackets shift to long-term capital gains tax brackets of 0%, 15%, or 20%, depending on your level of taxable income. If your income is low enough, you could potentially pay 0% tax on any long-term gains that are sold during a given tax year vs. 10% or 12% in taxes should you sell the investment before you exceed that year of ownership.
By knowing you’re going to sell an investment after at least 1 year to take advantage of the long-term capital gains tax rates, you can ignore a bit more the short-term, up-and-downs of the market. Taking advantage of long-term capital gains rates also illustrates another benefit of the buy-and-hold approach discussed above.
3. Use Tax Losses to Offset Gains
Another way to reduce your tax burden on any short-term or long-term gains in a given year is to harvest some losses from a down market to offset those gains. For example, should an investment be sold in a given tax year with a taxable gain of $5,000 and you sold another investment for a taxable loss of $4,000, these would offset and you would only have to pay taxes on $1,000 of gain. Also, should your losses exceed your gains in a given tax year, you can take up to an additional $3,000 of that excess loss to offset any other income. If you still have any remaining losses after that, you can carry them forward to subsequent tax years to reduce taxable income in the future.
4. Open and Contribute to Retirement Accounts
A powerful tool for tax strategy is to open and contribute to a retirement account. Some common retirement accounts include employer-sponsored 401(k)s and personal IRAs.
There are Traditional and Roth account types for each of these accounts, which in turn have their own benefits. If you were to contribute to a Traditional IRA or 401(k), you would get a tax deduction for the amount that you contribute into these accounts in a given tax year. This would lower your taxable income, which can lead to lower taxes in the year of the contribution. Your account then grows, over the long-term, and those gains are not taxable until you start withdrawing from these accounts. So, by contributing to traditional retirement accounts you defer the taxes until retirement.
On the other hand, there are Roth 401(k)s and IRAs. With these accounts, you don’t get a tax benefit for contributions in a given tax year, which means you have paid taxes on the amounts that you contribute. By paying taxes on the contributions to any Roth account, your account grows tax free and at retirement any withdrawals from that account are also tax free.
Depending on your taxable income and your eligibility for Roth contributions, you may prefer a traditional over a Roth retirement account, or vice-versa. Where you think your tax bracket will be in the future can play a key role in that decision, which was covered in more detail by Matthew Benson, CFP® in his guest article on Fox Peterson’s blog.
5. Roth Conversions
More specific to down market or lower-income years, you may want to consider a Roth conversion. For example, if you have pass-through business (e.g., LLC) losses in a given year and a traditional retirement account, you could take the traditional account and convert it to a Roth account. The conversion amount would be added to your income for taxes but would also net against the business losses to lower or even completely offset any taxes generated by the Roth conversion. A big advantage to doing this during market downturns is that when the markets rebound all of those gains have grown tax free and can be withdrawn tax free at retirement.
Of course, you shouldn’t try to time tax efficiency, just like your financial advisor would tell you not to time the market. But when you see an opportunity to take advantage of your tax situation, these 5 strategies can help reduce your tax burden while preserving your investment plan.
*Fox Peterson LLC and Sonmore Financial, LLC are not affiliated.