Down Market Can Give You a Surprise 2008 Tax Break

There are several little-known but completely legal things you can do to reduce your tax burden, “harvest tax losses,” and take best advantage of the Emergency Economic Stabilization Act of 2008.

Undo your 2008 Roth IRA conversion—then do it over again at a lower amount. “Recharacterizing” a Roth conversion sounds almost too good to be true, but it’s a perfectly legal and smart way to cut your taxes.

Suppose you converted your standard IRA, which was worth $50,000 in May, to a Roth IRA. That $50,000 counts as taxable income. But now your Roth IRA is worth only $30,000. Seems unfair. Well, you can undo, or “recharacterize” the conversion by sending the money back to your standard IRA. Next, you convert your standard IRA, now worth $30,000, to a Roth again. Voila: you’ve cut your taxable income by $20,000.

To do a Roth conversion, your modified adjusted gross income must be $100,000 or less, whether you’re single or married filing jointly.

The bailout bill can bail you out—if you exercised incentive stock options. The Emergency Economic Stabilization Act of 2008 includes a little-known provision that forgives underpayment of tax, interest, and penalties arising from exercising ISOs before Jan. 1, 2008. These penalties arose from “phantom income” produced by ISOs that declined in value but nevertheless stuck their unlucky holders with a hefty alternative minimum tax bill.

The bill abolished the alternative minimum tax on ISOs exercised before that date. If you’ve already paid the alt min tax on them, you can get your money back, and if you didn’t, you can get the underpayment penalties refunded. Consult a tax pro to see if this applies to you, Merrick advises.

“Harvest” tax losses using ETFs or index funds. If you have an investment that went down in value, you can sell it, take a capital loss, and replace it with a similar investment. This produces a tax loss without altering your investment strategy. The loss can be used to offset any realized investment gains or reduce your income if your losses more than offset your gains.

This move works especially well with ETFs and index mutual funds, Merrick says. For instance, say you sell ABC Energy ETF at a loss. You then use the proceeds to buy XYZ Energy ETF. This avoids the problems of wash sales that prevent you from taking a loss if you buy back the same security within 30 days.

Doris Merrick, CPA, had 30 years of experience as a tax manager with national CPA firms and as a trust officer with major banks before joining Brinton Eaton Wealth Advisors, a leading fee-only financial-planning, tax-advisory, and investment-management firm in Madison, N.J., in 2007. Web: http://www.brintoneaton.com.