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Five Strategies for Underwater Investments

Last update on: Oct 17 2017

We’ve done better than most investors since the market peak in March 2000, including the most recent market decline. Even so, you still might own some underwater investments, especially in your Core Portfolio. For example, American Century Income & Growth has declined with the general market.
These underwater investments can be used productively to minimize their impact and hasten the recovery of your wealth. Here are a few strategies to consider now.

  • Reconsider converting all or part of a regular IRA into a Roth IRA.Income and gains in each type of IRA are not taxed. Most distributions from a Roth IRA, however, are tax free, while regular IRA distributions are taxed as ordinary income. In addition, a Roth IRA owner does not have to begin required minimum distributions after age 70 1/2 the way a regular IRA owner does.A regular IRA can be converted into a Roth IRA. You must have adjusted gross income of no more than $100,000 for the year to do a conversion. (The income limit is the same whether you are married filing jointly or single.) In addition, you must include the converted amount in income for the year (this does not count against the AGI limit) and pay taxes as though that amount were distributed to you. (There is no early distribution penalty on the converted amount if you are under age 59 1/2.) You can convert all or part of a regular IRA to a Roth IRA.

    For a conversion to make sense, you have to avoid distributions from the converted account for years, usually 10 years or more. Time and tax deferral allow compound returns to make up for the tax paid on the conversion. For the conversion to make sense, the taxes should be paid from other sources instead of from the IRA.

    If the account value has declined, it will cost less to do the conversion than in the past. In addition, some people who could not convert in the past because their income was too high might be eligible this year because of capital losses or reduced income.

    You can convert now and change your mind later. You have until April 15 to decide whether to go ahead with the conversion or save the tax dollars. In addition, you still can change your mind through next Oct. 15. Just recharacterize the account by then and the IRS will return the taxes you paid.


  • This is an opportunity to bank losses. Long-term capital losses reduce capital gains for the year. When losses exceed gains, up to $3,000 of the losses can be deducted against other income. Any additional losses can be carried forward to future years to be used until they are exhausted or you pass away. Your heirs cannot use the carried forward losses.A market decline is a good opportunity to create a bank of these losses.Even if you want to hold an investment for the long-term, you can bank the losses as long as the “wash sale” rules are avoided. The wash sale rules disallow a loss deduction if a “substantially identical” investment was purchased within 30 days before or after the sale.  Instead of deducting the loss, it is added to your tax basis in the new investment. That reduces future gains or increases future losses on the investment. There are two methods to avoid the wash sale rules.

    When you own mutual funds, a losing fund investment can be sold and a competing fund purchased at the same time. Different mutual funds are not considered to be substantially identical, even if they have similar investment styles. By purchasing a competing fund at the same time, you are ensured of not being out of the market and missing any sudden surge that might occur after your sale of the first fund.

    The other method is to wait at least 31 days after the sale and re-purchase the fund that was sold. You would want to do this if you really prefer owning the specific fund for the long term. You take the risk, however, that the market will turnaround during the waiting period and you will miss significant gains.


  • Estate planning opportunities, especially gift giving, increase in a market decline.Larger gifts of property can be given tax free than before the decline. Each person can give up to $11,000 of property tax free to any other person each year. Married couples can jointly give up to $22,000. The market decline means you can give more stock or mutual fund shares to a person and get them out of your estate than you could have a few months ago.When the investment is worth holding for the long term because it is expected to appreciate, now is the time to make gifts and get more shares out of your estate. If you have a long-term gift giving program, don’t wait until the end of the year to make the gifts. Do the giving now while asset values are low.

    Consider gifts even if you have exceeded the tax-free amount for the year. You still have a lifetime estate and gift tax credit that allows additional tax free gifts either now or through your will that can total up to $1,000,000. This will increase in the coming years. It makes sense to use up part of this credit now while asset prices are down. If you continue to hold the assets and they appreciate, more of your lifetime credit will be used to give the same assets.

    Of course, be careful not to give more wealth than you can afford to do without. The first priority is to maintain your standard of living. Estate planning and tax reduction come after that.

  • Plan to cash in future gains at a lower cost. Most people don’t realize that there is a special super low capital gains tax rate for property held for more than five years. The top rate for those who qualify is 8% for those in the regular 10% or 15% brackets and 18% for everyone else.Children can make use of the lower bracket to finance their education and reduce the family’s taxes. Suppose you own assets that will be used to pay for a child’s or grandchild’s education. You have held these assets for more than five years. Selling them would incur capital gains, though the gains will be lower than in the recent past.Instead, you can give the assets to the child. He’ll take the same tax basis as you and also will take your holding period. That child can sell the assets and pay taxes at the 8% rate. Because the asset values are down, it is a good idea to give them away now instead of later when they are likely to have appreciated.


  • Review section 529 college savings plans. These accounts might have account values that are lower than the contributions to the accounts. These losses can qualify as miscellaneous itemized deductions for the owner if the account is closed. If you itemize deductions, miscel-laneous itemized expenses reduce your taxes only to the extent the total exceeds 2% of adjusted gross income. You also should re-invest the proceeds in a different state’s plan instead of another plan at the same state to avoid any problems with the wash sale rules. If you have more than one account for a beneficiary with that state, you probably should close all the accounts to take the deduction. Also, check to see if you might be subject to the alternative minimum tax before making the move. The AMT could take away all or most of the loss deduction.



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