Two Portfolio Moves To Make Right Now

It's not what you think.

China's struggling economy has caused global market disruptions. U.S. stocks bottomed out on August 25th with a 10.4% year-to-date loss. Despite rallying, we can't be sure if the uptick yesterday and today will sustain itself. For all we know, the market could easily be either 10% lower or higher by the end of the year.

What financial planners do know is although it's extremely difficult to time the markets, investors can execute strategic trades during general market inflection points to gain an advantage. The advantages aren't performance oriented, but for many investors a little trading can have an advantageous tax impact.

If you own investments that are down right now (compared to the price you paid for the investments), you can sell investments for a tax loss (called harvesting) and / or execute a Roth Conversion. This post will explore those two tax related strategies which could save you on your tax bill in 2015 and in retirement. I won't focus on why world markets are suffering from China's economy. If you want a summary on that click HERE.

What To Do In Your Taxable (non-retirement) Accounts. The strategy entails selling investments that have depreciated in value since your purchase date. The Internal Revenue Code allows an investor to claim up to $3,000 per year in investment losses. If you own a taxable portfolio investing in the major stock asset classes (US, International, & Emerging Market Stocks), the stock components of your allocation have behaved something like this over the last week of market trading:

US Stocks (-7.1%) International Stocks (-7.1%) Emerging Markets (-8.3%) Blue: China (-11.5%)

Let's assume you purchased $100,000 worth of ACME Mutual Fund (a hypothetical fund I made up) earlier this year. If that fund is down 8%, on paper it's now worth $92,000. If you sold ACME Mutual Fund you'd realize an investment loss of $8,000. On your 2015 federal tax return, you could claim up to $3,000 to offset ordinary income or other taxable gains. Investment income is normally taxed at 15%, so claiming $3,000 of investment loss nets the average investor $450 in deductions. I'm simplifying a tad- but you get the idea.

3 Things To Consider. If you're in the 15% bracket or lower, tax loss harvesting won't really benefit you. Probably skip the loss harvest. If you have more than $3,000 of loss, that's ok. Just keep track of the total loss. The IRS lets an investor carry over the leftover losses into future years. Using my example above, you could claim $3,000 in 2015, another $3,000 in 2016, and the remaining $2,000 in 2017. Assuming you retain your 25% effective tax rate, that's $2,000 saved on your next three returns. Last and most important, don't sell and sit on the cash. You have to reinvest the ACME Mutual Fund sale in proceeds in something else to capture potential gains. Sitting on the cash waiting for things to get better most likely will result in missing out. If you fail to reinvest, all you've done is lock in your losses. Bad....

What To Do In Your Retirement Accounts. The IRS allows any investor to take money from a Traditional IRA, SIMPLE IRA, or SEP IRA and convert it to a Roth IRA. This is referred to as a Roth Conversion. Some 401(k) plans also allow you to execute a Roth Conversion within the plan. A Roth Conversion is potentially very advantageous because when Roth IRA distributions are tax fee, unlike other IRAs in which distributions are normally taxed at ordinary income rates.

Let's assume you're 50 years old, married, plan to take distributions starting at age 65, currently reside in the 25% bracket, and plan to ratchet down to the 15% bracket once retired. Here's the advantage of converting:

That's a $4,759 net after tax advantage. Imagine if you had a $500,000 IRA and you converted $10,000 to $25,000 each year. You'd have $100,000+ in extra in net after tax dollars. That's about a year's extra worth of retirement income, or approximately 10 family trips to Hawaii. Imagine if you executed a Roth Conversion each year AND stayed in the 25% bracket. Your net after tax dollar amount be even greater compared to residing in the 15% throughout retirement.

If you're wondering, the $33,670 "Traditional IRA + invest $2,500 Roth tax payment" represents the scenario where instead of converting, you simply contribute $2,500 into an IRA versus coughing it up when the Roth Conversion tax bill arrives. While it's true this would be the best strategy on paper, the reality is most investors already contribute the max amount to an IRA each year. For most investors, maxing out IRA contributions and executing at least a partial Roth Conversion will still yield the best net after tax return.

There Are A Few Gotchas With Roth Conversions. This post is already too long, so I won't cover them all here. What I'll tell you to do is call your advisor and inquire if a Roth Conversion in any amount makes sense. The big reason to consider a Roth Conversion right now is let's say you're interested in converting the whole IRA (versus just a part of it); since the balance is probably lower right now than it was last week, the conversion dollar amount is smaller than it would have been. A smaller conversion amount equates to fewer current taxes paid.

Sorry If I Disappointed You. No, there's no magical portfolio shuffle you should engage in. You couldn't have anticipated the market drop nor could you have timed your re-entry. The strategies above involve your after tax return, and you won't even see the first benefits until April, 2016.

Every investor's situation is unique. With all the moving parts in either strategy, it's impossible to say how much, if any, you'll benefit. If you're not highly educated on the theory, execution, and pitfalls of each strategy, do yourself a favor and seek experienced counsel. I'm always willing to help or at least steer you in the right direction.