Last month, the third of the three major US indices (the Dow) entered a bear market, defined as a drop of 20% from its peak (marked in January of this year). It’s no secret that this year has been challenging for investors across the spectrum, as both stocks and bonds have been hit hard and in tandem. There have been few places to hide, as even the safety of cash has been pummeled by inflation the likes of which we haven’t seen in 40+ years.
If you know me, you know I am bent towards liking to be in control. The markets aren’t usually a good balm for that itch, which is one of the many reasons I love financial planning. The latter lets us take more control over our situation and gives greater perspective on the role of the markets. With that in mind, I wanted to dust off a piece I put together during the throes of the pandemic downturn (April 2020) about planning opportunities in challenging markets. As this year’s situation is different than what we were dealing with then, it wasn’t enough to just re-publish that original piece (for example, that piece suggested refinancing your mortgage…something you would likely be foolish to do today with rates now over 6%!). Instead, we have made updates that reflect the current market environment, current tax law, and the fact that we’re just three months from year-end (always an important planning deadline).
What hasn’t changed from that original piece is:
- We are going to focus on high-level introductions to each of these key topics, rather than lengthening this piece with all the minutiae of how things work and whether this would be a good fit for you. We have more in-depth pieces on each topic if you want to explore them in greater detail.
- We encourage you to contact us to see how these strategies might fit into your financial plan. Remember, they should always be considered in the broader context, so that you don’t save a dollar only to cost yourself a hundred down the road!
ROTH CONVERSIONS
Converting pre-tax (Traditional) retirement dollars to after-tax (Roth) can be a powerful planning tool, both for your lifetime and for your estate. This move can significantly reduce taxes and increase flexibility. We are currently in a low tax rate environment, and this is likely to change in the years ahead (the Tax Cuts and Jobs Act rates expire in 2025, unless Congress decides to extend them). With IRA account balances down, in some cases significantly, you can use this opportunity to execute a Roth conversion in a much more tax-friendly manner. For example, you could convert a greater percentage of your account at the same tax cost as you would have incurred on a much smaller percentage at the start of the year, or you could convert the same percentage as previously planned and pay a much lower tax bill doing so. Here are these two examples illustrated:
Note that you can choose to do this conversion “in-kind,” meaning you simply transfer existing assets from one account (the Traditional IRA) to the other (the Roth IRA). This allows you to stay invested throughout this process, thus avoiding the risk of being out of the market if/when it starts to bounce back
One key, in our opinion, to making Roth conversions effective is to not need proceeds from the IRA to pay the taxes that will be due on the conversion. Ideally, you want to be able to convert 100% of the intended amount, rather than have part of the funds leak out in order to pay the tax man next spring. This consideration is important as you decide on the appropriate amount to convert. Note that we’ll talk next about tax loss harvesting. You can use up to $3,000 of net realized losses against ordinary income, which can help to further offset the tax burden of this Roth conversion.
There are many important tax and planning considerations that must be carefully weighed before deciding to execute this strategy, especially since any conversions cannot be undone (“recharacterized”). Reach out to us and/or your tax professional to talk through the details and determine if this strategy is suitable for you.
TAX LOSS HARVESTING
If you have a taxable investment account (non-retirement), you are likely sitting on some unrealized losses as a result of this recent downturn. Selectively harvesting these losses, whether they be in equities or fixed income, can provide meaningful tax savings, both this year and possibly in future years. You can use losses to offset against gains you have been hesitant to take for tax reasons, or you can accumulate losses that can be used to offset ordinary income tax liabilities this year (up to $3,000) and future capital gains by carrying these losses forward. Strict rules do apply, and we also caution against letting the “tax tail wag the investment dog.” However, by carefully navigating these “wash sale” rules and strategizing about how to remain in the market with exposures that make sense for you, you can use this opportunity to sensibly rebalance your portfolio and minimize tax obligations.
NET UNREALIZED “DEPRECIATION”
This one is certainly not going to apply to most of you, but for those it does, it can be powerful long-term tax savings tool based on the Net Realized Appreciation (NUA) rule. We’ll spare you the details, and instead say this – if you own company stock within your 401(k) and that stock is now trading at a price significantly lower than what you paid for it within that account, please reach out to us and we’ll walk you through how this strategy works for you. It truly is a no-brainer when it applies.
Read our piece on Net Unrealized Appreciation
GIFTING
For those of you with asset levels that will trigger estate taxation at either the state or federal level, now can be a very opportune time to consider both simple and complex gifting strategies to reduce or eliminate any potential estate taxation. The combination of depressed asset values and still relatively low interest rates opens up a variety of gifting techniques for consideration, whether they are to your heirs or to charitable organizations dear to your heart. We will be glad to work with you and your estate attorney to strategize on methodologies that make sense for you.
ESTATE VALUATIONS
In the unfortunate case that a loved one whose estate was subject to taxation died in the last six months, this downturn in asset valuations can have a meaningfully positive impact on estate taxes due. By using the alternative valuation date, which is six months after the date of death, you can potentially lower the estate taxes owed thanks to the likely decrease in asset values over the past few months. Please note that there are also potential disadvantages to using this, so please consult with your estate attorney before making this irrevocable decision. It is important to note that if the estate was non-taxable (which is very often the case), it very rarely (if ever) makes sense to opt for lowering estate valuations, as this disadvantages those that inherited property with a step-up in cost basis.
EXERCISING STOCK OPTIONS
For those of you holding stock options, the current environment may be an opportune time to exercise those options, assuming of course that they are still “in the money.” For non-qualified stock options, the bargain element is taxable as W2 wages in the year of exercise. This means that by exercising the option at a lower strike price, you can significantly reduce taxation of these valuable assets. If you hold Incentive Stock Options (ISO), which are often reserved for executives or granted to the earliest employees of a start-up, the current environment offers you the opportunity to exercise many or all of your options with a much lower chance of triggering the dreaded AMT (Alternative Minimum Tax).
INVEST THAT EXCESS CASH
While we do not know if the elusive market bottom has yet been found, we do know that assets are trading at a significant discount to their prior highs. Yes, those highs could have been artificial in the short run, but history tells us that markets always recover and surpass those highs given enough time. As the market tries to find a bottom, we think it’s a prudent time to consider how you want to put excess cash to work at this relative discount (in both stocks and bonds). This doesn’t have to mean pouring it all in at once, though you may want to if you are 25 and have a 40+ year time horizon! A more prudent approach might be to dollar cost average in over the next few months. It depends on your risk tolerance and timeframe, and we encourage you to talk with us to determine what might be appropriate for you. The important thing is to have a plan and stick to it. Buying in this kind of environment is not for the faint of heart, but often leads to meaningful gains over time.
ADJUST YOUR SPENDING
This one applies to those of you currently utilizing your investment portfolios to cover living expenses. No one loves to be told to spend less (and no one loves giving that advice, including us!). But what if we framed it as “spend less now, so you can spend more in the long run.” That’s effectively what we’re suggesting here. Flexibility in your spending is something I highlight in every financial plan for those in or approaching retirement. In our opinion, the static “4% rule” or anything like it is sub-optimal. It’s a good place to start, but it ignores the realities of compounding and sequence of return risk. Here is a chart from the invaluable JP Morgan’s 2022 Guide to Retirement that illustrates the potential importance of being flexible with your spending (“dynamic spending” is how they term it). In this example, the solid line represents someone who maintained a constant spending level (adjusted for inflation) throughout retirement. The dotted line represents someone who dynamically adjusted their withdrawals based on the performance of the account (including increasing them during times of strong performance). You can see that, in this example, the dynamic spender was able to sustain their portfolio for an additional 10 years. For full details on how this illustration was constructed, click on the image below to see it in finer detail (or simply contact us for an explanation).
TAKE SOCIAL SECURITY NOW
If you have reached an age where taking Social Security is an option, but you have decided to wait – you may want to re-consider. Choosing to take your benefits now may mean less reliance on your portfolio assets during this down market, which in turn allows your accounts to recover more favorably. Note that this is a complicated subject and getting into the many considerations is beyond the scope of this brief paper. We do invite you to reach out to us if this idea needs to be a part of your considerations.
WRAPPING IT UP
We hope you have found this to be a helpful starting point. For those of you who are fully engaged with us in the planning process, we are already actively thinking about or implementing many of these strategies with and for you, oftentimes in concert with your tax and legal professionals. For those who would like to take a deeper dive into the planning process (or if you know someone who would benefit from doing so), please do not hesitate to reach out. After all, sticking to a plan is a lot easier if you have one to start with!
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Please also reach out to us if you have suggestions for other topics we should cover in future briefings. Thanks for reading!