Don't Mess With Taxes

With markets down, it could be time to harvest tax losses or perhaps convert a traditional IRA to a Roth retirement account.

What's scarier than Superman, the 415-foot tower roller coaster at Six Flags Magic Mountain in Valencia, California, that hits triple digit speeds? Some investors might say the recent stock market gyrations. (Photo courtesy Six Flags)

Is the recent stock market drop freaking you out? How about the roller coaster ride back up, at least for a while, today?

Yeah, it's worse than many stomach-churning amusement park rides and I'm right there, holding a barf bag, with you.

But don't take the next step. No, I'm not talking about the emergency nausea bag.

Don't panic.

Remember, if you've still got many years before you need the money, you probably should hang in there.

Even if there's a recession — and yes, that's looking more likely right now — sticking to our long-term investment plan probably will protect you.

Patience could pay off: Individual investors who hung in there when stocks tanked starting in 2008 (the markets hit the bear bottom on March 9, 2009) saw their holdings recover nicely.

In fact, sample portfolios of $100,000 that owners held actually produced triple digit cumulative total returns.

Of course, as the investment advisers say, past performance is no guarantee of future results. But it does indicate, to paraphrase an old proverb, that acting haste can indeed mean you repent in poorer leisure.

Note, too, that your losses, regardless of how large they are, aren't really real until you act. A stock sitting in your portfolio with a dramatically deflated price certainly is a cause for distress, but until you actually dump it, it's only a paper loss.

Losses reduce taxable gains: OK, you've decided that it is the time to get out of the market and turn that paper loss into an actual one.

The move, in addition to easing your mind as to how much lower markets could go, also could present a bit of possible good tax news.

The Tax Cuts and Jobs Act (TCJA) didn't change the tax value of capital losses.

You still can sell assets that have lost value, known as tax loss harvesting, and use that amount to offset any gains.

This means that if you've already taken some capital gains this year during the market run up, you can reduce the taxable amount by any losses you take now when you file your return next year.

The losses also can offset other gains you might have this year, such as capital gains distributions that usually show up in stock funds at the end of the year even if the overall value of the fund drops.

And if your capital losses are larger than your gains, you can use up to $3,000 of that amount to reduce your ordinary income.

Take NIIT notice: Tax loss harvesting also can help if you face the added net investment income tax (NIIT).

While the TCJA reduced many taxes for wealthier individuals, it left in place the NIIT. This surtax took effect in 2013 and imposes an additional 3.8 percent tax one of two ways.

It's collected on a filer's net investment income, which includes interest, dividends and capital gains, as well as rental income from real estate, royalty income from energy assets or even intellectual property rights and passive business income.

Or the NIIT applies to the amount by which a taxpayer's modified adjusted gross income (MAGI) exceeds a certain threshold amount. The NIIT kick-in levels, which are not indexed for inflation, are:

A quick note here. The NIIT does not apply to home-sale profits, which already are exempt from taxation when they are $250,000 or less for single home sellers, twice that amount for married joint filers.

Roth conversion opportunity: When the market goes down, it's also a good time to consider converting a traditional IRA to a Roth retirement account.

A Roth IRA is a great option for many. Its biggest tax appeal is that you pay taxes on the money you put into the Roth, but when you start taking distributions in retirement, those amounts are tax free.

If you do convert, you will have to pay tax on an amount you move from a traditional IRA, where the money has been sitting and growing tax-deferred, to a Roth IRA.

But since the TCJA has lowered the ordinary tax rates for everyone, you could take advantage of today's lower tax rates, which will go back up in 2026 unless Congress extends them.

A down market also is a tax bonus in a traditional-to-Roth IRA conversion. Converting amid a falling market means you'll pay income taxes on a lower portfolio value.

No more do-overs: Don't, however, let the tax possibilities be your only consideration. If you convert a traditional IRA to a Roth now, the move is permanent.

Under prior tax law, you could convert a traditional IRA to a Roth and then, if your personal financial circumstances or retirement account value changed, you could change it back.

This process, known as recharacterizing, meant things were like before and you didn't have to pay the tax on the amount you initially wanted to convert to a Roth IRA.

That's no longer possible. The TCJA eliminated the IRS recharacterization option. Make the move from traditional to Roth IRA and it's now a Roth forever, conversion taxes and all.

If you still think it's time to go Roth, consider converting incrementally. You can move a small amount of your traditional IRA now and, depending on what the market does down the road, convert more to a Roth as the year end nears.

And here's one final piece of advice when it comes to making any changes to your portfolio.

Whether you decide to make one or both of these potential tax-saving stock related moves, talk with your tax and financial planner(s) first. He or she can give you big picture advice based on their years of working with you and your money.

Update, Aug. 23, 2019: The market tumbled again today, primarily due to Donald J. Trump's social media comments regarding the Federal Reserve Board and trade with China. So I decided to get this stock losses post out there again, this time, fittingly, via my tumblr blog Tumbling Taxes. Enjoy the roller coaster video! 

You also might find these items of interest:

• 5 retirement plan and tax saving options 
• Retirement plan inflation adjustments for 2019
• Senators duke it out over capital gains inflation in letters to Treasury Department

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