Top 3 Year-End Tax Planning Strategies in a Down Market

Sometimes the markets take us on quite a ride over the course of a year. If you find yourself nearing the end of the year facing portfolio losses, use it as an opportunity to take advantage of some effective tax planning strategies. If you are the kind of person who finds checklists helpful, we’ve compiled some key areas to review in this 3 Top Tax Planning Strategies for Yearend Checklist. Below, we’ll further highlight the top three strategies to consider when experiencing a down market.

1. Tax Loss Harvesting

Tax-efficiency represents a perpetual challenge for taxable brokerage accounts, requiring you to weigh the pros and cons of sticking close to your long-term investment targets and minimizing capital gains taxes. Allowing the portfolio to drift too far from its targets could lead to an unsuitable asset allocation based on your risk and return expectations. On the other hand, selling positions in a rising market can create a meaningful tax drag, stifling the long-term growth potential of the portfolio.

Tax loss harvesting presents an opportunity to increase the tax-efficiency of your taxable investment portfolio. Suppose you hold a position that has dropped in value and is now worth less than the purchase price. You can choose to sell that position to realize the loss for tax purposes, and then take the proceeds from the sale and purchase a similar security. This allows you to maintain exposure to the market while realizing a tax loss that can be used to offset portfolio gains.

This strategy is even beneficial for taxpayers who do not have realized gains to offset in the current year. See IRS Topic no. 409 for the maximum capital losses that can be used to offset ordinary income; losses above that level can be carried forward to offset gains in future years. Using this strategy to defer taxes can have a meaningful impact on the long-term after-tax growth of a portfolio.

When utilizing this strategy, an understanding of the IRS wash-sale rule is critical. If an investor makes a purchase of the same security, or a security that is deemed to be “Substantially Identical” either 30 days prior to or following the tax-loss-harvest trade, a wash sale will be triggered. If a wash sale occurs, the realization of the loss will be disallowed, but the loss will be carried forward and added to the cost basis of the newly purchased position.

2. Roth Conversions

A Roth Conversion involves taking funds in a traditional IRA and transferring them into a Roth IRA. While this transfer results in a tax liability in the current year, any appreciation that occurs in the Roth IRA will be tax-free, as long as certain age and holding period provisions are met.

This strategy is most beneficial when your current marginal tax bracket is lower than your expected bracket in the future. Furthermore, utilizing this strategy during a market downturn allows you to convert a larger share quantity without pushing yourself into a higher bracket. This allows you to participate in the recovery with funds held in a tax-free environment.

We highly recommend consulting a qualified tax professional due to the analysis that must be performed to effectively utilize this strategy. When considering this strategy, you should generally aim to pay the income taxes due from another source, rather than having taxes withheld at the time of conversion. This will allow for the greatest amount of dollars to be transferred to the Roth IRA, and if you’re under the age of 59 ½, it will ensure that you do not inadvertently subject yourself to the 10% early withdrawal penalty.

3. Reduce Concentrated Positions

Concentrated positions in a single stock pose a significant risk to your long-term financial success. While many fortunes are created through concentrated holdings, it is also one of the fastest ways a family’s financial well-being can be destroyed. Often one of the most painful elements of diversifying away from a concentrated position is the tax burden that it’ll create. Selling a concentrated position during a market downturn can reduce the magnitude of the tax hit you will face. By taking the proceeds and putting them into a diversified portfolio, you can still position yourself to participate in the recovery while also reducing your reliance on the performance of a single stock.

If you have specific questions as we near year-end or would like to understand if you can benefit from any of these tax strategies, reach out to your Coldstream team. We look forward to working with you and your CPA to understand what options may be available to you.

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