The tax year is almost over, but the big swings in the financial markets over the past two years have created some interesting opportunities that can play out differently for each individual or family, depending on what you own and what your goals are. Environments like this are one of the primary reasons that we lead with financial planning in our investment management process - a thorough understanding of an investor’s assets, income, prior decisions, future plans, and life goals will spotlight the most beneficial strategy. Below are our top three tax strategies that we have used with our clients in 2022 for you to consider as you toast the new year.
Harvest tax losses
The idea of “harvesting losses” is seldom appealing to investors, but the truth is that most portfolios will experience some losses at some point in time. The strategy behind harvesting losses for tax purposes is very technical, but the idea is simple: lock in tax losses to offset future gains but stay invested. This is also a superb time to use losses to offset gains in growth-oriented investments, which may have performed well over the past few years but will be more challenged in a world with higher interest rates and higher inflation. Investors who consider this strategy should work in conjunction with a tax or financial advisor to review how harvesting may affect the rest of their tax picture and to avoid wash sales.
Case Study: An investor has held a growth fund for five years, but she doesn’t believe the fund will continue to perform as well over the next few years and wants to reposition to another investment. Due to the strong performance of the fund, she has a high level of built-up taxable gains. She also invested in an S&P 500 ETF in 2021, which has lost value this year. She can sell the S&P 500 ETF at a loss, pair it with the gains from the growth fund that she is selling, and reduce or eliminate taxes.
Convert Traditional IRA dollars to Roth IRA dollars
We talk about Roth conversions every year because simply put, we love the idea of money being tax-free. When you convert Traditional IRA funds to a Roth, you pay taxes now on the dollars you convert. The benefit is that those dollars grow tax-free from that point forward. Roth IRA conversions are a good opportunity for those in lower tax brackets and those who have enough savings to pay the tax bill on the conversion. We have found that ideal candidates for Roth conversions are those that are young enough to use the tax-free funds as future sources of income, those who want to leave a tax-free legacy to future generations, and those that have unusual tax circumstances for one or more years.
Case Study: An entrepreneur sold his company in 2021 and decided not to work for two years to spend more time with his daughter before she goes to college. His family’s taxable income will be almost zero during those two years. He can consider “filling up” the 22% tax bracket (capped at $178,150 for married filing jointly in 2022), or even the 24% bracket (capped at $340,100 for MFJ in 2022) with dollars he converts to a Roth.
Gift stock or other assets to a charity or Donor Advised Fund
Even though the stock and bond markets have had a rough year, the previous years created large gains for many investors. Instead of giving cash to a nonprofit, you can give stock, mutual funds, or ETF shares to a nonprofit. You can deduct the full price of the donated shares, but neither you nor the nonprofit pays tax on the gain. If you want to build an account for future nonprofit contributions, you can consider a Donor Advised Fund, which allows you to make a tax-deductible contribution now but send the money to your charity of choice when the time is right. Heard about Donor Advised Funds but don’t totally understand how they work? Check out this brief video from Communities Foundation of Texas.
Case Study: A corporate executive has a very lucrative compensation package and will be in the highest tax bracket for the next few years. Her family is very philanthropic, and she wants to be able to continue to donate to nonprofits in retirement. She funds a Donor Advised Fund now to receive a current-year tax deduction and to build assets to be able to give away in retirement.
At BFS Advisory Group, we live at the intersection of financial planning and investment management. Years like this, when the financial markets have a significant setback, are beneficial times to review both your high-level strategies and the tactical opportunities that can be executed with intentional, well-timed transactions. Earlier this year, we advocated that our readers adopt a year-round tax strategy, and tax planning is a continuous conversation with our clients. Hopefully, these ideas are a reminder of some ideas to consider before year-end.
If you need guidance on how to be more strategic with your taxes, portfolio, or philanthropic goals, contact us at hello@bfsadvisorygroup.com.
Sergio Garcia is a CERTIFIED FINANCIAL PLANNER™ Professional and Managing Director of Financial Planning at BFS Advisory Group. He uses the proprietary program, DBT360 Financial Plan, to help clients prioritize their goals, leverage their resources, and address their risks. The planners at BFS Advisory Group teach the public and the financial services industry about the importance of values-based financial planning and investor education.