When the market drops it is our natural tendency to want to make changes to our investment strategy despite a plethora of research that points to the optimal course of action being no action at all. When we log-in and see red on the screen, our fight or flight response kicks in and while that response served our ancestors well when a lion emerged on the savannah, it does us no favors in investing.
While changing your investment strategy will likely do more harm than good, you can still make smart financial planning decisions to make the most of a change in market conditions. Below we will outline several planning strategies that can be implemented during a period of market stress.
Rebalance Portfolio
The simplest action that you can take is to rebalance your portfolio to its target allocation. During periods of market stress, your investments can become disconnected from their target weighting – often the equity investments falling below target and the fixed income and cash components rising above target.
When you rebalance your portfolio, you will sell from the assets that are above target and use the proceeds to buy investments that have fallen below target allowing you to systematically buy low and sell high. Most investors struggle with having the discipline to ‘lean in’ during times of market stress and this is the easiest and most systematic way to do so.
Add Cash to your Portfolio
While we would generally discourage raising cash in hopes of jumping in during a crash that may or may not happen, if you find yourself with extra cash to deploy then a market downturn is a great time to deploy it.
Many people looking to add cash struggle with the timing of putting the funds to work. They want to time the bottom perfectly and are often afraid of investing the funds too early. We would encourage someone to not focus on trying to perfectly time the downturn – the fact that you are adding when most people are subtracting puts you ahead of most.
If you do think you might let emotions take over and question your decision should the market continue to drop then a dollar cost averaging approach can be used. By breaking the funds up into systematic equal periodic payments, you help mitigate the regret that may be caused from a lump sum addition upfront dropping in value.
Front-Load Tax-Deferred Accounts
A tax-efficient way to add cash to your portfolio is to front-load tax-deferred investment accounts you may hold. This strategy allows you to buy low and avoid the capital gains that would’ve come down the road from selling the low-basis shares.
If you have a 401(k), you can increase your contribution rate though you will want to make sure doing so won’t cost you any employer match. If you have not maxed out your IRA or HSA contributions for the year, this is a great time to get those accounts funded.
Complete Roth Conversions
If you are planning to complete a Roth conversion in the year then during a downturn is an optimal time to do so. Because the IRS taxes you based on the dollar amount converted at the time of conversion you are able to shift a greater proportion of your assets from tax-deferred to tax-free when you convert during a down market period.
Dave has an IRA worth $1 million and has determined that he can convert $100,000 this year without going into the next tax bracket. During the year, there is a market correction and his portfolio declines by 30% and Dave decides this is an optimal time to complete his conversion. At the time of his conversion, his total IRA account was worth $700,000 meaning his conversion represented 14.28% of his IRA value (vs. 10% at the start of the year). Because a larger percentage of his IRA is being converted, when the market recovers to the pre-downturn level his Roth IRA balance will be greater than the $100,000 he was originally going to convert.
Take Required Minimum Distribution
Many retirees with healthy retirement account balances later in life find themselves in a position where they are required to withdraw much more than they need each year. Depending on their heirs and estate plan, they also may find themselves worrying about the tax impact of a child being required to withdraw whatever retirement funds they inherit in 10 years.
When the market turns down, by taking their required minimum distribution they are withdrawing a greater proportion of their IRA and lowering both their future RMD’s and the required amount an heir would be required to withdraw. Assuming they reinvest the funds, they are now allocated in an account that is accessible at favorable capital gains tax rates and would likely receive a step-up in basis when inherited down the road.
Dave has an IRA worth $1 million and he must take $62,500 this year to satisfy his required minimum distribution. During the year, the market corrects 30% and Dave decides this is an optimal time to take his required distribution. At the time of the distribution, his withdrawal represents 8.9% of his account balance (vs. 6.25% at the start of the year). If appropriate, he can now employ his Roth conversion strategy at reduced values given his required distribution is now satisfied.
Tax-Loss Harvest
While we never invest with the intentions that an investment will decline in value all investors must understand that it will happen. When it does, the tax code provides benefits that can be utilized to reduce current and future tax burdens.
If an investment is sold for a loss the investor can use it to first offset any gains they may have for the year and then against their taxable income up to $3,000. Any unused losses can then be rolled over to be utilized the following year.
The proceeds from the sale can then be reinvested in a different security to ensure that any market recovery is participated in to the extent that the new security appreciates. The IRS wash sale rule requires that any security sold for a loss not be re-invested in for the 30 days before and the 30 days after the date the security is sold.
Gifting to Family Members
The annual gift tax exclusion for 2022 is $16,000 per person per recipient. This means that any amount given by one person to another person over that amount must be reported and will count against your lifetime gift and estate tax exclusion amount.
The current gift and estate tax exclusion amount is quite high at $12,060,000 per person but with talks that this number will likely come down – and possibly significantly – it can be valuable to preserve your exclusion to the extent you are able.
If you are planning on gifting assets to remove from your estate a downturn can be an optimal time to do so as the percentage that gift makes of your overall estate rises. Additionally, appreciated stock that is gifted to a family member in a lower capital gains bracket can potentially reduce the tax liability when sold down the road.
When markets decline the savvy investor looks to financial planning moves they can make as opposed to investment changes that disrupt their plan. If you have questions about any of these strategies and how they might fit into your plan schedule an introductory call to review your situation.
Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Keep in mind that there is no assurance that any strategy will ultimately be successful or profitable nor protect against a loss. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. IRA tax deductibility and contribution eligibility may be restricted if your income exceeds certain limits, please consult with a financial professional for more information.
