Keeping a focus on the bright side may not have been easy in recent months, given the market’s tumultuous start to 2016. But in ensuring that clients are grounded and have their eyes on the long term, it’s smart to plan to take advantage of some silver linings in all this market volatility.
First and foremost, in taxable accounts, a good strategy is to harvest portfolio losses when volatility strikes, in order to offset gains elsewhere in the portfolio. Many investors wait until year-end to harvest losses, much in the same way they hastily clean out their closets over the holidays to claim a charitable deduction for the year.
Harvesting throughout the year in response to market declines can maximize the value of this strategy, however. And, quite frankly, when we harvest losses and then invest the sale proceeds in a similar but not identical securities per the IRS’ wash sale rule, we often satisfy clients’ desire to do something in response to the market — all without altering their asset allocation, and while booking valuable losses.
TURNING LEMONS INTO LEMONADE
There’s also a way to turn lemons into lemonade in tax-deferred accounts, such as IRAs. What’s more, talking about retirement plans with clients certainly helps to keep them squarely focused on the long term. During the recent market decline, some of my clients have converted a traditional IRA to a Roth IRA. (Remember, there are income limitations as to who can open a Roth, but anyone can convert a traditional IRA to a Roth IRA.)
And many clients might want a Roth. After all, qualified Roth withdrawals will be tax-free. In addition, because Roth withdrawals don’t count as modified adjusted gross income, they don’t impact a client’s tax thresholds for the 3.8% Medicare surtax or Social Security income taxation. And there are no required minimum distributions. That provides some real planning flexibility, something that can be of particular benefit in extreme markets.
Yet clients often balk at converting a traditional IRA into a Roth because the converted amount is added to their income. So taxes are due. Here’s where the volatile market helps us: When an IRA declines in value, the conversion taxes will not be quite so burdensome. And once in a Roth account, all future appreciation on those converted assets is tax free.
To be clear, not everyone with a traditional IRA account that’s down in value should convert to a Roth. Depending on the size of the conversion, the move to a Roth could increase a client’s taxable income to the point where he or she is bumped into a higher federal income tax bracket.
Also, if you expect a client’s taxable income in retirement will be significantly lower than it is now, the potential future value of a Roth’s tax-free distributions would be reduced or even negated. And, again, the client needs to have enough cash on hand to pay the conversion taxes.
