My dad taught me to look for the silver lining in every cloud. This common expression is meant to convey that even the worst events or situations have some positive aspects. Growing up on a farm in Central Pennsylvania taught me valuable life lessons, including making the best of your current circumstances. For example, I remember one year when corn prices were very low. Instead of selling our corn to the mill, my dad started raising hogs. Why? Hog prices were up and Dad reasoned that corn could be put to better use to fatten hogs that would later be sold at auction.
This year, the financial markets went into a steep dive after reaching an all-time high in February. Rather than looking for opportunities created by lower markets, many people sit around and complain about how much their investment accounts have declined. When the market hands you lemons, I say it is time to make lemonade. Here are five ways to take advantage of the market downturn:
Harvest Losses in Taxable Accounts
Investment positions that are currently worth less than what they were purchased for can be sold to realize a tax loss. Capital losses can be used to offset realized capital gains. If total losses exceed total gains, taxpayers can offset ordinary income up to $3,000 per year. Any net loss over $3,000 can be carried forward into future years until the losses are used completely.
There are several reasons why taxpayers would want to do this. First, it can lower your current tax liability in many ways. The obvious reduction of $3,000 in taxable income can lead to lower tax on your Social Security benefits for retirees; higher deductibility of medical expenses for taxpayers that itemized deductions, and lower the Medicare surtax for taxpayers in higher tax brackets.
Secondly, the stock market should eventually recover. Having a loss carry forward into future years can help reduce taxes on capital gains during the stock market recovery. Tax brackets may not stay as low as they are now when the federal government turns its attention to paying for all the economic stimulus packages. Loss carryforwards could help offset future tax increases.
Keep in mind that tax-loss harvesting is a strategy that only applies to taxable accounts. Tax-deferred retirement accounts like IRAs and 401(k)s grow deferred, so they aren’t subject to capital gains taxes.
Perform Roth Conversions
This is a great time to consider converting funds held in a tax-deferred account to a Roth IRA. The conversion will create a taxable event this year requiring payment of income taxes on the amount converted. Paying taxes this year is the downside. However, all the post-conversion earnings in the Roth IRA will be tax-free after they are in the Roth for five years and you reach the age of 59½.
The goal is to convert IRA assets while they are at depressed levels to maximize the amount of the conversion. Current individual income tax rates are still relatively low under the Tax Cuts and Jobs Act. The rate of tax paid on the amount converted could be a lot lower than in future years. This shifts money from pre-tax savings to tax-free savings, which should be beneficial in the long-term by having less to pay taxes on in future years. I suggest speaking with your tax adviser before proceeding to decide on a reasonable amount to convert.
Evaluate Employer Stock in Your Company Retirement Account (NUA)
Holding employer stock in a 401(k) plan could have significant tax advantages at retirement. Funds distributed from a retirement account are normally considered ordinary income, which could currently be taxed as high as 37%. Through a special tax treatment called Net Unrealized Appreciation (or NUA), employer stock distributed from the company retirement plan is taxed at ordinary income rates based on what was paid for the stock. The value of the stock above the cost could be taxed as capital gains, currently taxed at a maximum of 20%. This strategy is most effective if your cost basis in the company stock is very low compared to the current value. (There are specific tax rules to follow to get this treatment. Consult a tax professional to see if you qualify).
Gift to Family
The annual gift exclusion is $15,000 per person. This means that a couple can each give $15,000 (total of $30,000) to each of their children and not pay gift tax or file a gift-tax return. People who are looking to pass assets to their heirs should consider taking advantage of lower asset values in their stock and real-estate holdings. Even if you exceed the $15,000 limit, there is a current lifetime gift exclusion of $11,580,000 before the gift tax is levied. You would also need to file a gift tax return to report the gift and keep track of the amount given.
Last, But Not Least, Invest
Not everyone can take advantage of the four items listed above, but many can take advantage of lower prices in the financial markets. It is easy to be fearful of what is going to happen in the market this month, this quarter, this year. Instead, investors should be looking beyond what happens in any one year. History has taught us that the financial markets eventually recover and move higher.
Americans are creative and innovative people and American companies are quick to adapt. The ultimate resource is human ingenuity—company profits and long-term prosperity are driven by it. Don’t wait for the stock market to go up before investing. If you have at least a five-year time horizon, consider taking advantage of the lower market values by investing now. You may never get another chance to buy into the stock market at these levels.
• Even the worst events or situations have some positive aspects.
• Having a loss carryforward will help reduce taxes on capital gains in future years.
• Don’t wait for the stock market to go up before investing; you’ll have already missed out.