Year End Bear Market Tax Moves--The stock market has been down this year, and we're approaching year end. It's a great time to take a look at your portfolio and make the best out of a situation that you might not like that much--your portfolio being down.
We talk through the best ways to make the best out of the situation--through your taxes. We discuss how to two tax strategies that can help you make the best a bear market.
00:00 Welcome!
00:47 Begin
01:23 Tip one
03:16 Sell low?
04:50 If you want to donate
07:11 Tip two
John's firm website: https://www.trinfin.com
For advisors around the US: https://www.acplanners.org/home
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TRANSCRIPT:
John: We're in the middle of a bear market as we record this, and that has a lot of people feeling down. But we're going to flip the script on that and talk about two reasons why we're excited about the bear market, and by the end of this episode, give you the information you need to be able to turn this in your favor. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel, and I've got a fee-only of financial planning practice in Chicago, Illinois. Before we start talking about how to take advantage of the market downturn, let's talk about subscribing. It helps our YouTube channel, helps us get credibility with YouTube, and helps us reach more people, so we really appreciate it if you go ahead and subscribe. John, I’m super excited about this.
John: Isn't it great that we’re in a bear market?
Bridget: Haha! 😊
John: What is wrong with you? People are not supposed to be excited about this. What I love about our conversations, Bridget, is that looking at the big picture and the facts behind the feelings on some of these things by asking, “What's going on?” We've talked in recent episodes about how the stock market isn't doing so hot; it hasn't done so well since the beginning of the year. And there's a bigger picture to that too, right? But there are some things that we can do today, some things that we can take advantage of to help that. And I know one of those things is something that you do a lot in your practice: tax loss harvesting.
Bridget: Yeah.
John: And we worry about getting into the jargon zone, tax loss harvesting, what the heck does that even mean? Let's talk about that. Maybe give a definition for that to start with.
Bridget: That's a great idea. Okay, so tax loss harvesting. Having a taxable account is the first thing that's important.
John: So not IRA, not Roth IRA, not 401K.
Bridget: Exactly. So you have a taxable account. You've bought it for, let's say, $10. And if the price is now $8…
John: I'm not so happy because I'm down by $2. I'm down 20%.
Bridget: Well, we're going to make some lemonade out of these lemons. It's not the best thing. We'd rather have it be up, but we're going to sell that, and then you get a loss and on your taxes. That will help you. If you are in a tax bracket, if you're paying some tax, that will help you.
John: Right.
Bridget: And each year it helps you up to $3,000, but first it offsets any gains you might have. Ok, so you lost $10. If you gain some money, then you have to offset that gain. And sometimes mutual funds do capital gain distributions. And so, again, it offsets gains first and then you can take a loss.
John: So here's one question that comes up periodically. And we are big believers in tax loss harvesting and being proactive, adding value on investments. It has nothing to do with picking the hot stocks or predicting the future.
Bridget: Right.
John: So here's a question that comes in. That was a perfect example. We bought something at $10 and now it's at $8. And we're going to sell that. But wait a minute, why do we want to sell low when things go down? You've said that it's only a paper loss until we sell it. Why are we taking a loss on this and locking in that loss?
Bridget: Because it'll help you on your taxes and then you can go buy something else. It's got to be different, but it can be the same value.
John: The example that I'll use for it is, if we're investing in oil stocks or Coca-Cola, and it goes down a little bit, we can sell it and buy Pepsi and we're still in that beverage market, if that's what we're looking at, those sorts of things. And so that's the explanation that I use, is that, yeah, we can't go back and buy Coke again for a while, right?
Bridget: 31 days.
John: Yeah, right. But we can buy something similar. And how we look at it is we don't buy individual stocks. Rather, we're going to sell this fund that has small companies in it and buy a different fund that has small companies in it. These are not exactly the same ones, but such that if today we have this much money in small companies, tomorrow we're going to have the same amount in small companies, but in the meantime, that loss goes on to our tax return, so we're not making a change in our investment philosophy or our allocation, we're just changing the specific investment to generate that tax benefit.
Bridget: Right, exactly. And so, this technique saves people a lot of money. And if you're of the donor class, you like to donate money, then what you can end up doing with these, what we call low, you're reducing the basis of your stock, or mutual fund, then it's a good one to donate. If it ends up going on around, you can avoid the gain and then make a donation, and take a loss on it, so it's really a nice strategy.
John: One question came up when we were having this exact conversation of how do we do this? And our clients said, “So what exactly happens with us? We take this loss, it offsets other gains, and then how long does that go for? How soon we have to use up those losses?”
Bridget: It goes in perpetuity as long as you're alive. So let's say you had $100,000 loss and that you have no other capital gains. Then you'd get $3,000 a year because that's the maximum…
John: For the next 33 years
Bridget: And the rest would carry forward. And if you're married, it goes to your spouse, so they do inherit it if you're married. If you're single and you die, however, it goes nowhere.
John: But it doesn't get lost. It's not like saying, “Well, if you don't use it this year, then goodbye.” No, it carries over. And we've had clients back going back to the 2007, 2008, 2009 bad years and eight or ten years where those things offset all their other gains and made all their other investment gains effectively tax free for those years.
Bridget: Right.
John: So it can be a big deal depending on how far it goes.
Bridget: Absolutely.
John: And so that's such a great way of taking advantage of losses. And somebody recently came to us and they had bought a stock because they thought, “During the pandemic, this at home thing is going to really take off.” And the company went down like 90%. Fortunately, this was a smallish amount of money, but a material amount of money at the same time. And so, making lemonade out of lemons. Rather than holding on to it until it comes back, I said, “Let's get out of that, diversify, and put that loss on your tax return to offset other things.” A great tool for that situation, and this goes into financial planning versus investment management.
Bridget: Right.
John: From an investment standpoint, it doesn't make any difference, but from a financial planning standpoint, from a tax standpoint, that can really make a big difference in people's portfolio.
Bridget: Yeah, that's a great distinction to make. Okay, so the next thing that we want to talk about, the second strategy, is Roth conversions. So, John, why don't you tell us what you tell people about Roth conversions?
John: Yeah, so a Roth conversion, just to make sure we're all on the same page, is taking IRA money that all went in pretax—we have a tax deduction when it went in, we haven't paid any taxes on this bucket of money—paying some taxes, and then putting it into Roth.
Bridget: Could I interrupt you quickly?
John: Absolutely.
Bridget: So it could be money that you originally put into a 401K and now is in an IRA.
John: Thank you for that! Exactly right on that. And I think the key component, as I think about it, is it's never been taxed before, so at some point we're going to pay taxes. I'm going to pay taxes, my wife, my kids, somebody's paying taxes, and choosing to pay taxes now at today's rates. And then when it's inside the Roth then, after that conversion, the future is all tax free, all future growth. So that's sort of the deal with that. And a lot of Roth conversion conversations today are focused on, well, today's tax rates versus tomorrow's tax rate, which makes sense for sure.
And we can argue and disagree about whether you should or shouldn't do it, but the focus, if tax rates are higher in the future, there's an advantage. Whether they're going to be higher, I don't know about that, but you go, “Okay, that's the focus.” This focus, though, for people to think about is, if you say, “Yeah, this is kind of appealing to do a conversion to turn some of my IRA money into Roth IRA,” think about what's going on in the market. If we have 1000 shares of XYZ stock and that's what's in my IRA—whatever the company is—and XYZ stock was trading at $100 a share.
At the beginning of the year, I had $100,000 worth of XYZ. Well, today maybe that's worth $80,000 or $60,000 or $20,000—we've taken a big loss on this. Well, the cost, if I had converted it at the beginning of the year and said, “Listen, I'm going to convert all thousand shares,” that means an extra $100,000 of taxable income. Now, if I converted and it's only at $60,000, I can convert the same 1000 shares, but it only is going to put $60,000 of taxes on my tax return.
So whatever that investment is down, we're saving that. If my investments down 40%, I'm going to pay 40% less in taxes on the exact same number of shares if I convert. And it's sort of counterintuitive to think, “How does this work?” And in from a practical standpoint, we often don't look at converting these shares, so it's often not as clean as that, but the concept is what makes. If you're going to convert something in an IRA, that loss means that you might pay less taxes on those things.
Bridget: So you're saying Roth conversions are on sale?
John: Perfect. Thank you for clarifying all that jargon. Roth conversions are on sale compared to the beginning of the year. If you're thinking about doing it, do it for cheaper. Who doesn't want to do things when they're on sale?
Bridget: Right. Exactly. Great time to do that. It’s great time to wrap it up. I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer, and I've got a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and I are actively taking on new clients, so feel free to reach out if you're looking for that. If you'd like to talk to somebody who's in your local area, both Bridget and I are members of the Alliance of Comprehensive Planners, so visit acplanners.org to find an advisor in your area who thinks along the same line that we do. And don't forget to hit that subscribe button.
Bridget: Thanks!
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.