Tax Planning Opportunities in a Shemozzle (aka 2020)

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Photo by icon0.com from Pexels

2020 can be described with many adjectives. Chaotic, unpleasant, snafu, and train wreck are just a few colorful terms (fit for print) I’ve heard to describe this year from, well, Hell. Maybe dumpster fire is the metaphor that came to mind for those that watched Jennifer Anniston struggle to extinguish a small fire Jimmy Kimmel set to kill germs on an Emmy award envelope earlier this week.

Fortunately for the winner, the envelope survived the inferno, and all was well. At least in Hollywood. For those of us that don’t make a living pretending to be other people, there may also be some lemonade to be made from the 2020 lemon, too.

Tax Loss Harvesting

Back in March, when the stock market was down by more than a third, there was a fleeting chance for Tax Loss Harvesting. That’s when you sell a stock for less than you bought it for and buy another reasonably similar one (but not the same), and then use the stock sold at a loss to offset any realized gains on others. This is a technique we use in taxable accounts to reduce or delay taxes for our customers. (Note, talk to an advisor before considering tax loss harvesting to avoid unexpected outcomes such as disallowed wash sales.)

Net Operating Loss

But 2020 hasn’t only been tough for stock investors that have had the stomach to ride it out. In fact, the market is about at the same level where it began the year as of today. For many business owners, however, the lockdowns and pandemic fears have led to significant loss of income. For those small businesses that survive the Covid Recession, lower profits and even net operating losses are likely this year.

A Net Operating Loss (NOL) occurs when business deductions exceed income. However, a NOL is another lemon that can be sweetened by astute business owners that operate as pass-through entities. One such instance is when the business owner has a pre-tax retirement account such as a Traditional IRA, SEP IRA, or Solo-401(k).

Roth Conversion

In a profitable year, contributions to those retirement accounts can be used to lower taxable income with the idea that taxes will be paid down the road when you are in a lower tax bracket. In a year when losses exceed income, making contributions may not be possible. However, the ability to “pay taxes” on previous contributions and earnings in a zero percent tax bracket may present itself. Even better, future growth of these dollars will convert from being tax-deferred to being tax-free.

The opportunity is known as a Roth conversion. Here is a simple example of how it may work.

Consider a sole proprietor who has a SEP IRA worth $500,000, and whose business experienced losses totaling $250,000 this year. Let’s also say the spouse’s annual income is $50,000. The loss is greater than household income, for a NOL of $200,000.

The business owners could just carry forward the loss into future years to apply towards future income. In some cases, they may even be able to apply it towards some prior years’ income.

In this case though, what if the couple converts $200,000 from the SEP IRA to a Roth IRA? Usually that would involve paying taxes on the converted IRA but this year they could use the NOL to offset the taxable conversion. The $200,000 that is now in the Roth IRA will then grow tax-free. It also will not be subject to Required Minimum Distributions (RMDs) when the owner turns 70.5 nor will there be any income tax due when left to beneficiaries.

Business owners that believe their tax brackets will be higher in the future may find this strategy to be especially attractive. Whether they believe their enterprise will return to profitability or that policy makers will eventually raise taxes to start paying down the $26,000,000,000,000+ national debt, using a Roth conversion to offset a NOL can be a savvy move in a year that is otherwise quite the shemozzle. (Credit to Laverne & Shirley for that one.)

These calculations can be complex and the rules can change from year to year, which is exactly what happened with this year’s CARES Act. Investors should consult with a tax professional to decide what is the best strategy for them. If you would like to discuss your situation, get in touch for a review.