Many an investor has soured on the continuing declines of the stock market. The Wall Street Journal reported on August 20 how investors can turn their stock losses into gains by using “tax-loss harvesting”. This strategy is that investors sell their poor-performing investments in their taxable portfolios to generate losses that are used to offset investments sold at capital gains or capital gain dividend distributions, and other income such as wages, interest or dividends up to the allowed $3,000 capital loss maximum loss that can be used in any one tax year. The investor then uses the sales proceeds to purchase other stocks or the same stock (avoiding the 30-day wash sale rule). The merits of this strategy have been questioned by some advisors as being short-sighted since the investor is “substituting” his higher basis stock (the stock being sold) for a lower basis stock (the stock being purchased). When the new stock is later sold, the likelihood is greater that the stock will be sold at a gain and taxed at capital gains rate greater than the current 15% rate.
Whether you agree with the “tax-loss harvesting” strategy or not, a colleague of mine commented that the above-referenced article failed to mention some terrific tax planning ideas. I would like to share these with you.
The recent decline in the stock market provides an extraordinary opportunity for taxpayers who made Roth IRA conversions in 2010 to reconsider and cancel or change those transactions. If you did a Roth conversion in 2010, you need to consider utilizing the “ROTH RECHARACTERIZATION” provision to nullify your 2010 conversion. You may have until 10/17/2011 to re-characterize your 2010 Roth conversion back to a traditional IRA.
Why should you re-characterize your Roth conversion? Well if you decided to convert $100,000 from a traditional IRA to a Roth IRA with the objective of reducing your future taxes, you are taxed on that $100,000 conversion. If your $100,000 conversion is now only worth $80,000 (due to market conditions), why pay taxes on the $100,000 conversion? The end result is that the re-characterization amount is treated as if it was never converted for tax purposes and is therefore not included as taxable income.
The re-characterization must be done using a “trustee to trustee” transfer. Any “earnings” (i.e., income and growth) must be included, but this is probably academic because the account value likely has declined more than any income received.
After using the Roth re-characterization provisions and nullifying the original 2010 conversion to a Roth IRA, you can then convert the $80,000 used in this example and now sitting in your traditional IRA account and convert it back to a Roth IRA. (Golfers would call this a “mulligan”. You get a second shot to obtain a better result without a penalty). Although this discussion focused on a 2010 Roth conversion, the same re-characterization principals apply to a 2011 Roth conversion that may have declined in value. Since there are time restrictions as to when you can “reconvert” from a traditional IRA to a Roth IRA again, and the rules differ depending upon the tax years of the original conversion and the re-characterization, you should consult with your tax advisor to ensure compliance with the IRS rules and regulations.
Another “benefit” of the decline in the economy is the opportunity to do business succession planning to transition ownership of a closely-held business from one generation to another. The value of the business may have declined along with the rest of the economy, and therefore more shares and a greater percentage ownership can be transferred now without increasing any taxes due on the transfer of the ownership interest to children and/or grandchildren.
The information here is not intended to replace specific tax-planning advice. Be sure to read the “Tax Advice Disclaimer” page on our blog.
