Recent gyrations in the stock market highlight an important opportunity for advisers: to provide clients with lessons on minimizing their tax bill. These opportunities exist year-round, not only at year-end or when the April 15 IRS deadline is looming.
Tax-loss harvesting, charitable contributions and Roth conversions are three strategies advisers should be tapping into, not just in December as some are prone to do, but throughout the year depending on the state of the market, advisers said.
“Tax planning is really a 12-month process,” said Neal Solomon, managing director at WealthPro. “People should be thinking about taxes and how they're going to try to minimize them all the time.”
Some advisers, such as John Voltaggio, senior wealth adviser for Northern Trust, say that a market correction or recession provide the biggest opportunity for tax-loss harvesting because that's when client portfolios are most likely to have taken a hit — and stock valuations may not be quite so rich.
Tax-loss harvesting involves selling assets that have incurred losses in taxable accounts to offset any taxes that would arise due to gains realized elsewhere in the portfolio. If losses exceed gains, they can be used to offset up to $3,000 of a client's ordinary income per year and, if any losses remain, they can be carried over to offset any future capital gains.
“You're generating some benefits, alpha, from down markets by realizing losses,” Mr. Voltaggio said. “If you just sit on your hands and don't proactively sell losses, you're costing your clients a lot of money.”
When it's done correctly, Mr. Voltaggio said, an investor will realize a loss and immediately reinvest the sale proceeds in a similar but not identical security to maintain market exposure. (Repurchasing the same investment within 30 days isn't allowed under current rules.) This means that it's imperative for advisers to have a plan in place ahead of time so they know what they're going to buy on behalf of the client, he added.
September could prove to be a good time to execute on that strategy, since it is historically the worst month of the year for markets.
However, tax savings shouldn't trump an overall investment plan for a client, Mr. Solomon cautions.
“Never make an investment decision solely based on taxes,” he said. “Taxes are something you keep in mind, but it's secondary to what you want to do with an investment portfolio.”
Making charitable contributions using long-term appreciated stock — stock that's been held for at least 12 months — is another tax strategy advisers said that they consider on a continual basis. Rather than writing a check to a charity, investors can donate the appreciated stock and pare back exposure in a particular security without paying any capital-gains taxes.
A donor-advised fund is a way to front-load these contributions into a calendar year, allowing clients to realize the full benefit of a tax deduction in one year but pay out the charitable contributions from the fund over time. Offsetting tax obligations resulting from a financial windfall, such as an IPO or business sale, is an example of when a donor-advised fund could be an appropriate vehicle.
Recent market movement has led Neela Hummel, a partner at Abacus Wealth Partners, to reconsider her strategy with donor-advised funds, though. When putting together a charitable strategy for a client, she usually makes several years' worth of contributions using a donor-advised fund, but she said wouldn't recommend that approach right now.
“There's a part of me that's holding off on making some of those [large] contributions and not making a huge contribution [that's] more than normal, because of the recent volatility,” Ms. Hummel said.
For example, instead of contributing appreciated shares worth $100,000 to a donor-advised fund to be paid out in $20,000 installments over five years, just contributing one year's worth, or $20,000, may be a better bet this year, Ms. Hummel explained. Due to the “extreme” volatility of late, “putting the brakes on a little bit” is warranted, she said.
Ms. Hummel also said a dip in the market provides a good opportunity for Roth conversions in individual retirement accounts, especially those with high balances. Clients in higher tax brackets may be hesitant to take a large tax hit years before it's absolutely necessary, but the hit on a converted account will be less in depressed markets, Ms. Hummel said, and then the account can grow tax-free afterward.
“You're taking advantage of the depressed values,” she said. “Once things recover, the best case is they recover when you're in the Roth.”