Copyright 2020 Tom Madell, PhD, Publisher
April 2020. Published Mar. 28, 2020. Updated: Mar. 29, 2020
by Tom Madell
These are tough times for everybody. Investors, if they can even take their minds off health concerns, suddenly may have to worry about their finances too. If you allow yourself to consider what you should do about the latter concerns, you may feel your options are extremely limited, with no clear way to escape the potential quagmires ahead. No one article can greatly improve the situation but perhaps a few tips can make somewhat of a difference for many investors.
As you are undoubtedly aware, since my last Newsletter, stock funds, and even some bond funds, have taken investors on a wild ride. That ride for stocks has been mostly downhill, while for most bonds, it has been mostly uphill.
There have been many articles in the media that have advised investors to what to do, either sell, buy, or hold, so I don't want to write another article that again tries to do that. Besides, I have already given my advice on that in the above mentioned Newsletter which was written before stocks entered a bear market.
If you ignored my early March advice to hold and did sell some stocks, you may be doing better than someone who had followed it, at least so far. But my advice was for the long term so although you may be somewhat ahead now, we don't know if you will still be ahead a few weeks from now, or more aptly, several years from now. To do so, you would need to get back into stocks with just the right timing, assuming stocks will at some point bounce back. Although it might seem easy to do this, hardly anyone, professionals included, is good at such attempts to time the market. In fact, research shows investors attempting this, regardless of the circumstances, usually do worse than those who don't.
So rather than offer advice on either selling stocks to try to sidestep the crisis, or buying if one thinks they see some excellent bargains given the drop in prices, in this article I will offer two tips that may help improve your bottom line over the next few years. While these are not totally unique suggestions, I personally have had some success in applying them during prior big market sell-offs. And since both strategies can help you save on taxes, an appropriate concern at this time of the year, you may want to give them a little thought.
Tip 1: Up until the bear market began just weeks ago, almost all of my long-term investments were "above water." That would mean that if I sold, or exchanged out of such an investment in my taxable accounts, I would be hit with capital gain taxes. (This is not true, though, for moves made in retirement-type accounts.)
Since having to pay additional capital gain taxes as a result of any mutual fund transactions, and even possibly pushing me into higher Federal and/or state tax brackets, has always been something I have tried to avoid, I quite rarely opt to sell or exchange from a taxable account. This has been true regardless of how high, or overvalued, such an investment might appear to me. Thus, if one is like me having both taxable and tax-deferred retirement accounts (or Roth accounts), they can often accomplish the same goal by transacting only from the latter accounts.
For example, if one wishes to reduce his/her allocation to Growth funds and has one in a retirement account as well as one in a taxable account, exchange out of the retirement account not the taxable account. This principle has always been true regardless of whether we are in a severe downdraft, such as now, or not.
Given the fact that some of my stock investments last month quickly went from above water to losses as compared to what I actually paid for the funds, i.e, the "cost basis" which is typically found on an account's website, I found myself having some losses amounting to thousands of dollars.
Of course, while these losses are not what any investor hopes to see, it is often a fact of investing that you will have them occasionally, even more likely in a bear market. But when investing hands you lemons, you can sometimes make lemonade. The one positive side of having such losses is that you can deduct capital gain losses from your remaining gains, or short of that, even from ordinary income when you file your taxes for that year.
While I cannot go into all the details of taxes for anyone unfamiliar with all this in this Newsletter, suffice it to say that while it is never your goal to have losses, you can use any losses that do occur to reduce your taxes. But for this to happen, you would need to actually sell the losing fund so long as its price is below your cost basis.
If and when its net asset value rises above that basis, you no longer have that loss. So if you are confident that the price will spring back in a while, you may not want to sell at all but just wait it out.
So here are the actions you can take to possibly improve your tax-related finances when filing 2020 tax returns next year:
Let's consider this scenario: Suppose you have concluded as I have, for a long time now, that a Large Cap Growth fund cannot just keep growing to the moon. You have wanted to sell some or all of your Growth fund for a while but didn't want to wind up paying higher taxes in terms of a capital gain next year. Therefore, if you now see you have a capital loss, you can sell that fund and redirect (i.e. exchange) the investment into another fund category that seems to have more positive prospects because it isn't overvalued as Growth appears to be. I believe there are at least two other fund categories that meet this criterion. They are International funds, and perhaps Value funds.
Obviously, there is no guarantee that by exchanging out of a Growth fund into one of these other categories of funds that the latter fund will do better than just by staying with the Growth fund, but even if it is just a 50/50 chance, you will nonetheless have succeeded in lowering your taxes for that year. But note that if you exchange out of a Large Cap Growth fund into another seemingly equivalent Large Cap Growth fund, the capital loss may be prohibited if the IRS notices it. However, you can re-invest into another Large Cap Growth fund or even the same one if you wait 30 days.
Similar to the example above, suppose you have a bond fund in a taxable account whose net asset value has gone down considerably since you bought it. This would most likely be the case if you owned a fund with a lot of lower quality bonds, also called "junk" bonds. For example, even one of the best low quality bond funds, Vanguard High Yield (VWEHX), has lost over 9% (thru 3-25) over the last year. Junk bonds often do poorly when stocks do because companies with low credit quality may default on their bond obligations especially if there is a recession.
If you decide that this category is now too risky to continue owning, you might want to capture that loss for tax purposes and switch to a higher quality bond fund. (Bond fund quality for any fund can be found at the morningstar.com site under the fund's "Portfolio" tab; look for the graphic "Fixed Income Style" which for VWEHX is shown as Low.) In order to maintain the same allocation to bonds in your portfolio, you can exchange the same cash value out of the low quality fund to a higher quality one.
Tip 2: This only applies if you have investments in an IRA and are required to take some money out because you are over 70. (Please check current IRS rules for details on these Required Minimum Distributions, or RMDs.)
If you have already started taking your RMD from your IRA (or will need to start this year) and have been expecting to have to do so for 2020, there is good news in the recently passed coronavirus relief bill just enacted into law. Specifically, you will not need to do it this year!
Normally, I wait until near the end of the year to make such withdrawals which in my case, plus my wife's, are rather substantial. This allows me to continue to keep my investments tax-deferred for as long as possible. As a result of being required to make these taxable withdrawals, our income and thus our tax due grows a lot larger. Unfortunately, once you reach that required age, there is nothing you can do to stop the yearly withdrawals from your IRA since the rules do not allow you to tax-defer your IRA forever, except for Roth IRAs.
But, as part of the virus relief package, IRA investors can now skip the withdrawals for this year, assuming you haven't already made them. Since IRA withdrawals are taxable as ordinary income, with rates as high as 37% for those in the highest tax bracket, plus any additional state tax due as well, by not taking your RMD this year could save you many thousands of dollars. It might also keep you in a lower tax bracket when your subsequent new yearly Medicare premiums are calculated for higher income taxpayers.
Note (3-29): Thanks to subscriber Ron Guarino, here is what you can do if you have already taken your 2020 RMD:
The RMD can be returned to IRA account but only within 60 of taking it. To do so, contact the fund company and request to do a INDIRECT ROLLOVER. If withholding has already been taken out, to fully avoid taxes on the distribution, you must also return the amount of tax taken out. See the following link for more detailed information.
What money I don't want to invest immediately in either stock or bond funds, I usually keep in a high quality money market fund, usually a tax-exempt one when parked in a taxable account. In fact, over the last few years, I have kept at least 15% of my portfolio in such funds. The reason for such a high allocation was that I figured stock prices were too high and therefore considerably risky. Bond prices did not seem to be a great bargain either since interest rates paid on bonds were extremely low and price appreciation for bonds seemed unlikely because further appreciation is usually a result of future drops in interest rates.
As it turned out, I was right about stock prices being too high, triggered into swooning in response to the COVID-19 crisis. However, bond prices have actually done quite well lately as investors, fearful of stocks, have continued to pour money into them, resulting in considerable price appreciation in spite of low dividend yields.
Up until the coronavirus crisis hit, most high quality taxable money market funds were paying approximately 1.5 to 1.75 % and about 1% for tax-exempt ones. Now, however, while taxable such funds are still paying about the same or even less, tax-exempt money market funds have jumped considerably as illustrated below by these ones offered by Vanguard:
*California Municipal Money Market 3.14%
*Vanguard Municipal Money Market 4.05%
*New Jersey Municipal Money Market 3.47%
*New York Municipal Money Market 4.02%
*Pennsylvania Municipal Money Market 4.80%
(SEC yields as of 3/24)
Normally, tax-free funds will yield considerably less than taxable funds as we saw before the crisis; an investor in tax-exempts though may still be getting a better deal because the tax-equivalent yield often surpasses the taxable one for many investors. However, right now at least, one is getting an even much better deal by investing in the tax-free funds. In fact, the yields now for the tax-free money market funds are even much better than investing in the somewhat riskier longer maturity municipal bond funds from Vanguard. So what gives?
I myself find it hard to explain exactly why this has happened but I suspect it has to do with investors pulling money out of municipal money market funds to get their hands on cash.
According to news reports, the Fed recently announced it was expanding money market support to include very short-term muni debt, the type of instruments within these tax-exempt money market funds. So the Fed decided to support money market funds that invested in this type of debt to make sure the funds can meet such redemptions.
Thus, the Fed move "could keep the mutual funds, popular investments among ordinary workers and companies, from crashing as investors cash out," according to this article. The article adds that "From Wall Street to Main Street, Americans are hoarding cash as the coronavirus upends businesses and threatens to plunge the nation into a deep recession." And rates keep moving rates higher to try to draw in new purchasers, according to one municipal bond manager.
While the muni money market rates may stay high for the short term, don't expect to get such a bonanza of good tax-free returns on a long-term basis. But it is a welcome happenstance for observant investors who take advantage while it lasts.
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