The Truth About The Market Sell-Off Effect On Your Taxes
Whether it is panic selling, hiding out in cash, or trading frantically during volatile markets, investors tend to make several mistakes that can hurt them long-term.
As troubling as market sell-offs can be, at least one feature often feels familiar, the effort to convince investors to avoid the serious investing mistakes that come from short-term thinking during a sell-off. If this recent volatility, has you rushing to get your money out of the stock market, be careful. Dumping stocks from your portfolio could create a big tax bill if you’re not cautious.
Our experienced Accountants and Bookkeepers understand the complexities of the financial world. That's why we want to help you navigate the recent market sell-off and understand its impact on your taxes.
If you’re invested for the long term, simply do nothing, and know that declines are a normal part of investing. But if you decide to sell shares that have gains, you are taking “capital gains.” Such gains are taxable. If these are short-term gains, i.e. you held stocks for less than 365 days, these gains are taxed at your ordinary-income rate. If you owned the shares for more than a year before you sold them, you have a long-term capital gain that’s taxed at a different (usually lower) rate: 0%, 15%, or 20%, depending on your income bracket for that year.
Keep in mind that you may have to pay state capital-gains taxes as well. Although It’s always smart to think about the tax effects of your financial decisions, never let tax avoidance become a substitute for wise investing decisions. Sell a stock only if it truly doesn’t work for you.
1. Do it in a tax-deferred account
If you want to reduce your exposure to the stock market, think about selling shares you might be holding inside your 401(k), IRA, or similar retirement vehicle. These retirement accounts are tax-deferred, which means whatever happens while the money is in that vehicle, it is not taxable until you decide to take money out of it. Only then do you start paying taxes. That means if you sell an investment within a tax-advantaged retirement account, you won’t be subject to paying capital gains taxes like you would in a taxable brokerage/individual account.
2. Sell the old stuff first
Since the tax on short-term capital gains is higher than the tax on long-term capital gains, look at how long you’ve owned the shares when you’re deciding who stays and who goes.
3. Sell some of your losers too
You may be able to offset some of your already realized gains by realizing some losses. This is called tax-loss harvesting. If you’ve lost money on one investment, you can sell another one at a profit and basically avoid capital gains.
However, please note that tax-loss harvesting has its limit. As your losses exceed your gains, you can deduct the difference on your tax return up to $3,000 per year ($1,500 for married filing separately). If you have more than $3,000 of realized losses this year, you can deduct up to $3,000 next year and keep deducting $3,000 per year going forward till you deduct all your realized losses.
4. Convert your traditional IRA to a Roth IRA
When the value of your stocks plunges due to a market sell-off, you can take advantage of that by converting some or all of your current IRA to Roth IRA. This will effectively grow that part of your retirement savings that is in your Roth IRA account tax-free going forward. This, of course, comes with a cost, which is, reporting the converted amount as income and paying its applicable income tax this current year.
Depending on your specific situation and income bracket, this may be a good strategy for comparing long-term benefits to short-term costs. As always, consult with your tax advisor/financial planner before you take any action.
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