By Mark Albers, Wipfli Financial Advisors, LLC and Ryan Laughlin, Wipfli LLP
In a few short weeks, stock markets have fallen from all-time highs to bear market (20+% drop) territory.
Many investors are left wondering what just happened and, perhaps more concerning, what happens next?
It is normal to feel compelled to protect your finances. However, making drastic changes to your portfolio at times like these - such as switching to cash until things settle down – are quite risky as well.
This article will give high-level overviews of several planning techniques that could allow you to take action during this bear market and try to capitalize on it.
All these techniques rely on one fundamental understanding: Stock market values increase over time. Not every day, and not predictably, but over time they trend upward and we expect to eventually recover any lost value and push even higher.
Lower account values in a bear market also create the potential to move money out of traditional retirement accounts at a lower income tax consequence.
Roth IRAs (individual retirement accounts) and Roth 401(k)s provide tax-free qualified distributions, whereas traditional IRAs and traditional 401(k)s create ordinary income to recipients when distributed. A Roth conversion involves converting dollars from your traditional IRA or 401(k) to your Roth IRA or 401(k). That creates income reportable on this year’s tax return and means you’d be paying the tax earlier than if you’d have left it in your traditional IRA or 401(k).
Why do that?
If your account is down 20% right now, you’d be able to only pay tax on that lower amount and the subsequent estimated recovery growth would happen in the Roth account to later come out tax-free. Additional considerations that make this strategy more enticing are the elimination of most stretch-IRAs after the SECURE Act, the lower current income tax rates through the Tax Cuts and Jobs Act (TCJA) of 2017, if you expect you may have a taxable estate, or if you think your tax rate may increase in the future.
Tax-loss harvesting is selling a security at a loss to create a capital loss that can be used on your tax return to offset capital gains, reduce ordinary income of up to $3,000 per year, and — if you do all of that and still have losses — the excess carries forward to future years.
Tax-loss harvesting is not just liquidating positions to generate the losses, but simultaneously investing in a similar position so that you’re still invested almost identically.
For example, hypothetical Fund A and Fund B are both U.S. Large Cap Value managers with nearly identical investment strategies and both are down 20% since you bought Fund A.
You can sell Fund A, which creates a capital loss, and buy Fund B the same day. That leaves you in essentially the same investment position but creates a capital loss that results in current tax savings.
The loss only applies if you don’t buy Fund A again within 30 days (before or after) the sale date.
This is more of a tax deferral than a pure tax savings since this lowers your cost basis in that investment, which could result in larger gains in the future. This strategy may be particularly helpful if you have a large capital gain currently or coming soon, such as the sale of property or a business.
Most investors have a target allocation of stocks, bonds, and other assets they strive to maintain. As categories rise and fall to different degrees, the overall account strays further from target.
For example, assume you started February at 60% stocks and 40% bonds and now your stock percentage is down to 53% and bonds are at 47%. By trimming 7% off your bond allocation and investing that in stocks, you’re selling high (bonds) and buying low (stocks), which is exactly the old market adage. It also means you should be in a better position to capture stock growth when the market does recover.
Account or security transfers
Certain securities or even entire accounts are often maintained without changes to avoid a large taxable gain triggered by changes. With prices down, those gains that were previously being worked around may be much more manageable or completely gone. Like with tax-loss harvesting, this doesn’t mean liquidating a security and leaving the proceeds in cash. Rather, this is an opportunity to move from a legacy investment into a preferred investment at a lower tax cost.
IRA, HSA, 401(k), other contributions
People often have recurring contributions setup to save money into certain accounts throughout the year, such as making their annual IRA, health savings account (HSA), or 401(k) contributions, or just adding to an after-tax brokerage account. While you should first be mindful of future cash flow needs you may have, you should consider accelerating some of those planned contributions if you can. Even though we can't predict when this outbreak will end, you can invest dollars now at a significant discount to prices from just one month ago.
Particularly if you may have a taxable estate, gifting to heirs is a powerful way to transfer wealth because you’re allowing future growth for the asset(s) you gift to take place outside of your estate. If you can leverage those gifts, that’s even more powerful. In some cases, that can be done through specific assets and special valuations, but a bear market creates the opportunity to gift securities at the current discount values and allowing the recovery to happen with the heirs.
Lending money to younger generations is an opportunity for the borrower to receive the benefits of the market's recovery. The lending family member would lend at a certain interest rate to avoid any gift taxes, and current rates are relatively low. The borrowing family member would then invest the borrowed funds and to the extent the money grows at a higher rate than the interest owed, the borrower keeps the difference.
Funding a Charitable Lead Annuity Trust
Charitable Lead Annuity Trusts (CLATs) provide a payment stream to charities for a set length of time, and then beneficiaries of the trust receive what is left, free of any taxes. The person setting up the trust may receive an income tax deduction in the year cash is contributed to the trust, so this works particularly well if done in a high-income year such as when a business sells or when doing a large Roth conversion as discussed above. The payments to charity are based on current interest rates, which are currently quite low, and to the extent the investment returns within the CLAT exceed that interest rate, more will be left for beneficiaries at the end.
We're here to help
If you need any help, your Wipfli or Wipfli Financial advisor can help go into more detail on any of the techniques that seem applicable to your situation.
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