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Staying Financially Fit by Turning Lemons into Lemonade

| October 16, 2018
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The recent market selloff that started on September 20th has left many wondering what to do next.  While this may leave you feeling concerned about your investments, market selloffs may provide an opportunity to reap potential tax benefits.  Below are two strategies you may want to consider while the markets and account values are depressed.

Roth Conversions

Converting pre-tax IRA dollars to after-tax Roth IRA's is a strategy that can prove beneficial and reduce one's overall tax burden over time.  Since amounts converted from pre-tax IRA's to Roth IRA's are subject to taxes in the year of the conversion, it is possible to reduce your tax bill on the conversion by converting while market values are depressed.  If you are able to convert all of your IRA's to Roth IRA's prior to reaching age 70.5 you will not be subject to Required Minimum Distributions (RMD's) which can reduce or potentially eliminate your Social Security and other income here to read Forbes article

Any amounts converted from pre-tax IRA's are subject to income taxes in the year of the conversion.  While this can be a tough pill to swallow in the year of the conversion, it is typically best to limit your conversion to amounts that will keep you from going into a higher marginal tax bracket.  This is most beneficial when you have funds outside of IRA's (ie. savings accounts, taxable brokerage accounts) with which to pay the taxes when they are due.  It is always best to communicate with and receive the advice of a tax professional prior to performing any conversions.  This is more important today as you can no longer undo a roth conversion as these recharacterizations were disallowed following the Tax Cuts and Jobs Act of 2018.

Harvesting Tax Losses

For those with taxable investment accounts, this may also provide a good opportunity to better diversify your portfolio. It is likely that your best performing investments have become a larger than expected piece of your portfolio and thus subjected you to more potential risk.  Many may have resisted selling due to the capital gains liability or to let their winners continue to run.  While no one knows when is the best time to sell their winners, there are ways to reduce or eliminate the tax impact of doing so.

This can best be done by strategically selling investments whose values are down and taking a capital loss , while at the same time selling or reducing investments that are up and taking a capital gain.  Since tax-loss harvesting can involve both long-term (held longer than one year) and short-term capital gains (held one year or less), there is a sequence to how the losses are applied.  Long-term losses are first applied against long-term gains, and then against short-term gains. Meanwhile, short-term losses are applied first to short-term gains. This sequence takes place because long-term capital gains are taxed at a lower tax rate than short-term capital gains.

While you can later re-purchase securities that were sold, it is important to avoid the wash-sale rule. This is a rule concocted by the IRS to prevent taxpayers from creating tax losses using investments. The rule requires that a loss on a sale will not be permitted if the same or substantially identical security is purchased within 30 days of the transaction that resulted in the loss. That means either 30 days before the sale or 30 days after.  A way to get around this is to make sure that you wait at least 31 days after the sale of investment to buy it back. You can also purchase a similar, but not identical, investment to the one sold. This could involve, for instance, selling shares in one oil company and immediately purchasing shares in a different oil company.

Control What You Can Control

Because no one has a crystal ball and can predict what life or the market will throw at you, it is important to focus on what you can control.  Having a financial plan that integrates your retirement plan, tax situation, investments, estate considerations and insurance protection will allow you to turn the lemons your are inevitably dealt in life into lemonade.

Nick Hughes, CFP®, is a Wealth Advisor with Franklin Wealth Management, a registered investment advisory firm in Hixson, Tennessee. In addition to advising clients since 2007, he has contributed to articles for Market Watch and and is a regular contributor to the Franklin Backstage Pass blog.  


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