2022 has been a challenging year for savers, investors, and their advisors. But such downturns can also provide opportunities. As the year comes to an end, we offer some practical action steps to review with your financial team to take advantage of investment losses by reducing taxable exposure from capital gains and other sources.
Consider Tax-Loss Harvesting
A Tax-Loss Harvesting strategy can be used to limit tax exposure from noninvestment, ordinary income such as wages. The possibilities from this strategy became more pronounced when the S&P 500 Index entered bear market territory this year. You may be able to harvest losses incurred in both equity and fixed income securities by selling some investments in taxable accounts that have lost value to offset capital gains elsewhere and help reduce taxes owed.
Under current law, a capital loss deduction allows an investor to claim up to $3,000 more in losses than in capital gains, meaning investors can reduce their taxable income dollar-for-dollar up to that $3,000 limit. However, there are IRS restrictions when selling securities using this strategy. For example, the wash rule seeks to prohibit short-term selling at a loss, then quickly buying the security back – the loss can’t be deducted unless one waits for 30 days to reinvest in the same asset.
Take your Required Minimum Distribution (RMD)
Annual Required Minimum Distributions (RMDs) are mandatory from Traditional IRAs and most employer retirement plans after attaining age 72. RMDs for the year—which are classified as taxable income—are based on the value of an account as of December 31st of the previous year. Unfortunately, in 2022, many investment accounts have lower values than they did on December 31st of last year. This is a concern for those taking RMDs from their qualified retirement accounts, such as IRAs or 401(k)s.
Let’s consider how your RMD is calculated. First, you will need to utilize the account balance for each Traditional IRA account from December 31st, 2021. Then, look up the life expectancy factor for your age in the appropriate table provided by the IRS. Divide the IRA value by the life expectancy factor. The result is your RMD for 2022. That is a simple explanation, but you will want to consult with your financial team on the best way to execute this, especially given the severity of the penalty you could face if you do not take an RMD—failure to take a distribution results in a 50% tax on the amount you were supposed to withdraw for the year.
Do a Qualified Charitable Distribution (QCD)
If you’re making charitable contributions and taking RMDs, consider making the donations using a Qualified Charitable Distribution (QCD). In 2015, Congress made the QCD exclusion permanent, allowing taxpayers who are at least 70½ years old to transfer up to $100,000 tax-free through charitable contributions made directly from an IRA to a charity.
The QCD rule allows Traditional IRA owners to deduct their RMDs on their tax returns if they give the money to a charity. The charitable contribution is excluded from the taxpayer’s gross income, but it counts toward the RMD for the year (provided the RMD hasn’t already been withdrawn).
This can effectively reduce your income taxes by lowering your Adjusted Goss Income (AGI), and may be the best way for someone age 70½ or older to contribute to charity. Contributions must take place before December 31, 2022.
Consider Roth Conversions
On the whole, mutual fund distributions will likely be lower in 2022 than they have been in recent years due to the market’s decline. If your tax withholdings (Payroll or Estimated Payments) are the same as last year when payouts were higher, an analysis of pursuing Roth conversions to net the same tax liability may be warranted. With a Roth conversion strategy, you convert all or part of your Traditional IRA to a Roth IRA and pay regular income taxes on the converted amount. Unlike tax-deferred retirement accounts, Roth IRAs aren't subject to required minimum distributions beginning at age 72. Also, recovery from this bear market will occur in the Roth IRA, providing you with growth that can compound over time as tax-free retirement income.
To qualify as a 2022 Roth conversion, the funds will need to be transferred from your Traditional IRA or company retirement plan by December 31, 2022. In 2022, you can contribute up to $6,000 to your Roth IRA if you're under 50 (or $7,000 if you're over 50), provided you're under the income limits. In 2023, you're free to contribute $6,500 if you're under 50 and $7,500 if you're 50 and older.
Although Roth conversions generate immediate taxation, you will be able to take advantage of today’s lower federal tax rates as they may increase in the future. If you are reluctant to absorb a big tax bill, you may want to consider executing smaller partial conversions over time to take advantage of lower tax brackets. If you are taking RMDs and do not need to draw on cash reserves for living expenses, using the RMD to pay the taxes on your Roth conversion may be a proper strategy for the reasons outlined above.
Roth conversions are permanent, so be certain there are enough funds to pay the taxes before completing the transaction. We would stress working with your CPA and evaluating the holdings as they are providing estimates of capital gains distributions.
Although financial markets have delivered numerous setbacks this year, those with taxable investment accounts have an opportunity to capitalize on several strategies that can reduce their tax exposure. With proper guidance from financial professionals, individuals can consider tax-loss harvesting, make required minimum distributions in advance of the deadline, pursue Qualified Charitable Distributions, and convert Traditional IRAs to Roth IRAs. Implementing these strategies can reduce individuals’ tax liabilities for this year and position their accounts for tax-free growth when the markets stabilize and eventually rebound. As always, please feel welcome to reach out to your advisory team at DBR & CO to discuss these and other strategies.
Thanks for reading.
This material has been provided for general, informational purposes only, represents only a summary of the topics discussed, and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice or recommendations. Rather, they simply reflect the opinions and views of the author. D. B. Root & Company, LLC. does not provide legal, tax, or accounting advice. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals for advice that is specific to your situation. There can be no assurance that any particular strategy or investment will prove profitable. This document contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information derived from such sources, and take no responsibility therefore. This document contains certain forward-looking statements signaled by words such as "anticipate," "expect", or "believe" that indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that the expectations, beliefs, views and opinions expressed in this document will come to pass. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The impact of the outbreak of COVID-19 on the economy is highly uncertain. Valuations and economic data may change more rapidly and significantly than under standard market conditions. COVID-19 has and will continue based on economic forecasts to have a material impact on the US and global economy for an unknown period.
Chief Planning Officer
Nancy I. Kunz
CFP®, CPFA®, ChFC®, CLU®