Investments that are worth less today than when you bought them may—somewhat counterintuitively—be great candidates for helping you work toward your financial goals. You just need to know when and how to deploy them.
To be sure, your personal circumstances also matter. While some moves are available to every investor, others make sense only for those with large incomes and account balances. The good news is there should be something for everyone. Let's take a look.
For all income levels
It's inevitable that you'll lose money on some investments and make a profit on others. But there is a bright side to those losing investments—they might help you lower your tax bill through a process called tax-loss harvesting.
It usually works like this. You sell an investment that has lost value since you bought it. Then, you use that loss to reduce your taxable capital gains, and potentially even offset some of your ordinary income.
For example, let's say you bought two batches of shares last year. Some were winners; some were losers. You decide to sell them all and end up with a short-term capital loss of $25,000 on one position and a $20,000 short-term gain on another.
Because you held the stock for a year or less, the gain would be treated as a short-term capital gain and taxed at ordinary-income rates—which tend to be higher—rather than lower long-term capital-gain rates, which apply to investments held for more than a year.
However, your $25,000 loss would offset the full $20,000 gain, meaning you'd owe no taxes on the gain. Plus, you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years.
Dollar-cost averaging just means investing the same amount of money regularly (say, every month), regardless of what the markets are doing. When prices are high, you buy fewer shares. And when prices are low, as many are today, you buy more shares with the same amount of money.
In fact, down markets can be a good time to contribute more to your 401(k) or individual retirement account (IRA), as your dollar goes further when assets are selling at depressed prices. Likewise, if you have more cash in a health savings account (HSA) than you'll need to cover out-of-pocket medical expenses for the next year or two, consider investing those excess funds.
Consider exercising incentive stock options (ISOs)
Down markets can also be a good time to exercise ISOs, particularly if you think you might be subject to the alternative minimum tax (for 2023, the AMT exemption is $81,300 for single filers or $126,500 for married filing jointly).
Once you meet holding period criteria for ISOs—two years from the grant and one year from the exercise date—the spread between the stock's fair market value and the exercise price of the option could be taxed at the lower long-term capital gains rate. However, if you go over the AMT exemption amounts your ISOs could lose some of their tax advantages: The spread could be taxed at the AMT tax rates in the tax year you exercise your options.
Given that, down markets can make for a great opportunity to exercise your options, because you can exercise more of them without going over the AMT exemption. Equity awards can be complicated, so make sure you check with your equity compensation planner and tax advisor before making any moves.
For the comfortably established
There are many appealing reasons to have some of your savings in a Roth IRA. Assets in a Roth IRA can accumulate tax-free. You pay no taxes on qualified distributions. You'll never have to take required minimum distributions (RMDs) from a Roth IRA, unlike with traditional IRAs and 401(k) accounts. Plus, even your heirs can take tax-free distributions from a Roth. These features help explain why some investors nearing retirement—and even those in it—prefer to convert some of the savings in their tax-deferred traditional IRAs and 401(k) accounts into Roth assets.
Of course, taxes are due on any sums you convert—but that's less an argument against conversions and more of one in favor of careful planning. In fact, the recent market drops could make conversions even more appealing than usual, as converting assets at lower prices could lower the resulting taxes. If the assets recoup their losses later, they could provide additional tax-free growth and withdrawals over time.
Do you have children or other relations with investing accounts? Because the logic behind Roth conversions could also apply to gifts that involve investing. The idea here is to take advantage of annual gift tax exclusion of $17,000 per person per year (or $34,000 for spouses "splitting" gifts) by gifting shares that you believe have appealing prospects but are temporarily trading at depressed prices. As a result, you can theoretically transfer more shares today than you might have in the past—for example, by moving them to your children's custodial accounts—without going over the annual exclusion amount.
The recipient typically owes no taxes on the gift, and they would be able to enjoy more of any future gains. To be clear, the recipient would be liable for taxes on any gains if they sold the gifted assets later. However, if they held the assets for a year or more—including prior owner's holding period—the gains would be subject to the lower capital gains tax rates. If they were in a lower tax bracket, their capital gains rate could even be 0%, meaning they might not have to pay taxes at all.
As a reminder, all gifts should be reported using IRS Form 709, but only those that go over the annual exclusion amount are taxable. Once you give more than the annual gift tax exclusion, you begin to eat into your lifetime gift and estate tax exemption ($12.92 million in 2023—more on this below).
This also goes for funding a 529 college saving plan. You can get more bang for your buck when the market is down by bundling five years of annual gift tax exclusion amounts—totaling up to $85,000 (or $170,000 per couple) in 2023—without reducing your lifetime gift tax exclusion amount.
For those with significant means
As suggested above, market downturns can be an excellent time to accelerate your wealth-transfer strategy. Transferring assets with values that are lower than normal can allow you to pass on wealth that may appreciate as markets improve, while also avoiding gift taxes. With the estate and gift exemption at an all-time high of $12.92 million per person in 2023 and the pending reduction of that exemption in 2026 (due to the Tax Cuts and Jobs Act sunsetting, effectively cutting the current estate and gift exemption in half), today may be an opportune time for wealth transfer.
Estate planning moves
- Grantor retained annuity trust (GRAT). Wealthy individuals and families looking to lighten the burden of gift and estate taxes could consider shifting assets they believe will appreciate substantially in their lifetime—perhaps as a result of a recovery from a significant market drop—into a GRAT. It works like this: The GRAT's creator transfers assets into a fixed-term, irrevocable trust. During the term (of at least two years), the creator receives annuity payments that pay the value of the assets back to them in their entirety—plus a fixed interest (or "hurdle") rate set by the IRS. When the term expires, any growth in the invested assets over and above the hurdle rate passes to the trust's beneficiaries tax-free.1
- Family Limited Partnership (FLP). A Family Limited Partnership (FLP) or Family Limited Liability Company (FLLC) can be an option for families looking to take advantage of depressed asset values by transferring interests in family businesses and real estate. Their structure enables you to transfer ownership of the underlying assets from one generation to the next without having to surrender control of those assets, while potentially reducing or avoiding transfer taxes thanks to the lifetime gift tax exclusion. Such structures can help keep ownership of a closely held business in the family, while also offering liability protection for the limited partners.
- Intentionally Defective Grantor Trust (IDGT). Families with large amounts of wealth can also secure potential tax savings by selling temporarily depressed assets to an intentionally defective grantor trust (IDGT). Such sales are known as a "freeze" technique because the value of the assets in the estate are frozen at the value on the date of transfer, and any future appreciation is shifted to the next generation. The trust is called "defective" because it is disregarded for income tax purposes, which means that the grantor (typically the senior generation) is required to pay income taxes on all income earned by the IDGT each year. In so doing, the grantor allows the trust assets to grow unencumbered by taxes—which is effectively a "free" gift to the trust each year. In return, the grantor receives interest payments back from the IDGT that aren't considered taxable income.
Because of the complexity involved in making significant gifts, we recommend starting a conversation with your financial, tax, and legal advisors as soon as possible to help ensure your goals are met.
The logic behind many of these moves is broadly similar: You can potentially do more with less, whether that means using losses to offset some of your gains or positioning your investments for a potentially more advantageous tax treatment for yourself or your heirs. As always, talk with a financial or tax professional before embarking on any major changes.
Hayden Adams, director of tax and wealth management at the Schwab Center for Financial Research; Austin Jarvis, director of estate, trust and high-net-worth tax at the Schwab Center for Financial Research; and Chris Kawashima, senior research analyst for Financial Planning at the Schwab Center for Financial Research contributed to this article.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Periodic investment plans (dollar-cost-averaging) do not assure a profit and do not protect against loss in declining markets.
Investing involves risks, including loss of principal.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.0223-34J5