When market volatility skyrockets, investors often feel at the mercy of wildly fluctuating portfolios.
They watch the value of their hard-earned dollars go up one day and plummet the next. It can feel like whiplash for investors with substantial portfolios and ambitious investment objectives.
No matter what the market outlook is today, investing always involves risk. Past performance is unfortunately not a guarantee of future results, so it’s not a question of if your portfolio will go down, but rather when.
Particularly during market declines—even short-term ones—investors still feel the need to act. Rather than selling out of all your stocks (thus missing out on the recovery), consider actions that could help you reduce taxes and make it to the other side in solid financial standing.
In this article, we’ll outline six tax-efficient investing strategies you can employ within your retirement and investment accounts to lower your tax burden amidst market uncertainty.
1. Place rebalancing trades inside a retirement account.
After significant market movement, you will need to rebalance your portfolio to keep your risk level consistent. Whenever you shift stocks or bonds back to their intended targets after a market movement, pay attention to whether you’re trading inside a taxable or retirement plan. This can make a significant difference in the tax treatment.
Your risk tolerance level may have you investing 70% in stocks and 30% in bond funds, for example. But the market decline may mean your allocation is now closer to 60% stocks and 40% bonds. In this case, that means you would sell bonds and buy stocks.
If those bonds’ values have appreciated since you first purchased them, then you would incur a capital gains tax upon selling.
If you place these trades inside a taxable account, you must report that gain as taxable income on the current year’s tax return and be subject to the current capital gains tax rate.
However, if you can conduct the rebalancing trades inside a retirement account — like an IRA, 401(k), or Roth IRA, you would avoid a tax bill.
2. Consider tax loss harvesting.
In the above strategy, trading inside a tax-exempt retirement account was ideal. But to take advantage of tax loss harvesting, trades would need to be placed inside a taxable account.
Here’s how it works:
Let’s say you are invested in a mutual fund that isn’t doing so well right now. Maybe that fund is currently at a $10,000 loss.
You could sell the fund, capture the $10,000 loss, and buy something similar to keep your overall asset allocation intact.
Tax loss harvesting has many benefits. It allows you to take advantage of a tax loss, keep your account properly balanced, and retain your exposure for when the market recovers.
Selling all of your equities at a loss and not repurchasing similar equities would not be ideal. That’s because you would be locking in your losses with no potential for recovery.
If this sounds a bit complicated, you aren't alone. Regular tax loss harvesting requires a consistent eye and understanding of things like the wash sale rule to execute effectively without penalty. If you're curious about tapping a professional to handle optimizing your financial plan across the board, start with our 2-minute plan analysis.
3. Consider Roth conversions.
If you’re in a lower tax bracket now than you will be later in your career, you could make Roth contributions or conversions. When the market is at a lower value, this can be a particularly advantageous investment decision.
When you do a Roth conversion, you take money from an IRA (which is tax-deferred) and move it into a Roth account. The value of your assets is the amount you’ll report as ordinary income on the current year’s tax return. However, that amount is the value of your assets on the day you make the conversion.
For example, say you moved 1,000 shares of a fund that was trading at $10 a share. You would report $10,000 of ordinary income on your next tax return.
Those 1,000 shares, now in your Roth account, will grow tax-free. If in six months those shares increase in value to $13 a share, your Roth account balance is $13,000.
Plus, you only had to pay taxes on the original $10,000. A word of caution, however: If your shares end up being worth less than when you originally bought them, there’s not much you can do to “reverse” your Roth conversion.
4. Contribute to retirement.
You may be subject to a higher tax rate now than you expect to be when you plan to make withdrawals from your retirement accounts. If so, making contributions to tax-advantaged accounts like a traditional IRA or 401(k) can be a significant strategy. When you make this portfolio decision, you get the tax deduction now.
For example, the contribution limit for a traditional IRA is $7,000 if you’re under 50 years old. For those over 50, it’s $8,000.
If you contribute the maximum amount pre-tax, you can deduct $7,000 (or $8,000) from your income on your next tax return. Whenever you do take money out of the IRA later, those distributions will be taxable at ordinary income rates.
On the other hand, you may be in a lower tax bracket now than you expect to be in later. If so, contributions to a Roth IRA or Roth 401(k) may be a better portfolio decision when thinking about how to minimize tax liability.
Although you’ll miss out on that $7,000 deduction now since the contribution is made after-tax, those funds will grow tax-free. When you withdraw money from the Roth IRA during your retirement, you can also do so tax-free.
No matter what account you contribute to, it’s often a good idea to take this step when the market is down. At the lower value, you’re able to purchase more shares with your dollars.
5. Practice charitable gifting.
If you’re in a high-income tax bracket, making a larger charitable contribution than usual can net you a tax deduction. Donor-Advised Funds, or DAFs, are a great way to accomplish this.
DAFs allow you to contribute several years’ worth of charitable gifts at once. Although the money can be distributed to charity over many years, you receive the tax deduction the year you add to the account.
Now that the standard deduction has increased, lumping several years’ worth of charitable contributions into one can be more beneficial. However, that’s only the case if it is enough to itemize your deductions instead of taking the standard deduction.
Qualified charitable distributions (QCDs) are also an option if you are over age 70.5. QCDs are distributions to charity from your pre-tax retirement savings. These are particularly beneficial once you start your Required Minimum Distributions (RMD) (age 73/75, depending on your year of birth), as they can offset your RMD and reduce the amount that is taxable to you.
6. Add to a 529 Plan.
Another tax reduction strategy you can leverage right now is to contribute to a 529 plan. A 529 plan is a savings plan for education-related expenses, and contributed funds grow tax-free.
Some states even offer a tax deduction for contributions to 529 plans. This investment option is particularly advantageous when the market is low. That’s because if the market recovery happens within the 529, that growth is tax free.
Portfolio Decisions: A Tale of Two Investors
How much of a difference can these tactics make when it comes to minimizing taxes and protecting your portfolio? To answer that question, let’s compare two investors: one who plans their investments around tax implications and one who doesn’t.
John’s Investment Strategy
John has good intentions to manage his money, but his career and family often take up most of his time.
Although he invested some money several years ago—adhering to a 70/30 allocation for stocks and bonds—he hasn’t done much with it since.
Now, his allocation has shifted to 85/15. As a result, his portfolio is more aggressive than he intended, making him more susceptible to investment losses during market declines.
He’s also neglected his Roth IRA and has amassed a small balance since he has forgotten to make annual contributions.
Although John does make charitable gifts, he doesn’t contribute enough to itemize his deductions—so he receives no tax benefit.
After a market downturn, John could have taken advantage of tax-loss harvesting to offset future gains. However, he didn’t pay enough attention to his finances to even know this was an option.
Jenny’s Investment Strategy
In comparison, Jenny realized she didn’t have the time or desire to deal with her investments on her own. She works with a financial advisor to make portfolio management and investment decisions.
She and her advisor have kept her 70/30 allocation intact through continual rebalancing over the years.
Now that the market is in a downturn, 30% of Jenny’s portfolio remains in safer asset locations (e.g., bonds). So, she’s less susceptible to market volatility. She also has made annual Roth contributions that have compounded over the years to a great size.
During the downturn, some of Jenny’s funds have lost value. Through tax loss harvesting, however, she captured $50,000 of losses. She can now use that to offset gains for several years on her tax returns.
Jenny also has been “bunching” her charitable donations, which enables her to receive a tax benefit every few years. In addition, she has been contributing to a 529 plan for her kid’s education. This has earned her a tax deduction now, and the money in the account grows tax-free.
Next Steps
When you think about how to handle your investments during a downturn, take a page from Jenny’s book. While taxes won’t be the sole driver of your investment decisions, they should be an important consideration.
Although you can’t control the stock market, there are plenty of proactive planning and tax reduction strategies you can take advantage of—in any market climate.
Is it time to get an experienced tax advisor on your side who can bring a wealth of experience and savvy tax strategies to your portfolio? The right wealth management team can develop a strategic tax-efficient financial plan for you, while focusing on your financial goals and legacy.
Take the first step toward your customized financial strategy today with our 2-minute financial analysis. It’ll pressure-test your current plan and uncover areas for optimization.
