One cannot overstate that these are very challenging times – emotionally and financially. As we all prioritize our lives under this new normal, it can be helpful to remember that there is a silver lining to every cloud. Here are a few ways that you can turn those “lemons into lemonade” which could provide great value once the clouds part.
When markets are down, your money can go farther. Consider making your retirement contributions now to take advantage of “buying low.” While no one can predict what will happen in the short-term, over the long-term, markets have historically rebounded and grown after drops of 20% or more, as you can see in the following chart:
If your traditional IRA has gone down in value recently, now may be an ideal time to convert those funds to a Roth IRA, potentially saving you money in taxes owed (the assets you convert will grow tax free). There is currently no limit on the amount of money you can convert, although in most situations, you will have to pay income taxes on what you convert.
Traditional IRAs are usually funded with pre-tax dollars. When you take money out, you pay taxes on those withdrawals at ordinary income rates. In contrast, Roth IRAs are funded with post-tax dollars. Money in Roth IRAs grows tax free and is withdrawn tax free if you are over age 59 ½ and your Roth IRA has been open for at least 5 years.
It can be very useful to have tax free money available in retirement, especially if you also have taxable income from other retirement accounts and/or Social Security. Roth IRAs also pass free of income taxes to heirs.
Roth IRAs are also an ideal asset for kids since they have such a long time horizon for those monies to grow. Kids do need earned income to be able to contribute to a Roth IRA, and they can only contribute up to the lesser of $6,000 (in 2020) or the amount they earn. Babysitting, mowing lawns, and W-2 income reported on the child’s tax return counts.
As a parent, you can open a custodial Roth IRA for your underage children. You can even contribute to the Roth IRA on their behalf, as long as their earned income at least equals what you contribute.
A 529 plan is a college savings plan. Funds grow tax-deferred, and, if used to pay for qualified educational expenses, can be withdrawn tax-free.
Because the funds inside a 529 are invested in the markets, making your 529 contribution now can take advantage of potentially lower prices and higher expected future growth.
As of 2020, each individual can contribute up to $15,000 per 529 beneficiary per year. The IRS also allows you to “frontload” 5 years of 529 contributions. That means a couple could contribute up to $150,000 in one year for one child or grandchild without owing any gift tax.
Interest rates are at historic lows, especially given the recent Federal Reserve interest rate cuts. If you have a mortgage or an established, seasoned note, you may want to explore refinancing it or simply paying it down early.
When markets are volatile, it’s especially important to stick to your target allocation of stocks versus bonds. When stocks drop faster than bonds, you may find that you are holding more in bonds on a percentage basis than you intend. Trim back on bonds and buy stocks to maintain your long-term asset allocation target. In short, “buy low and sell high.”
Anytime that markets move, you may find that a security (stock or bond) you hold has dropped in value below the price you paid for it. That means you have an “unrealized loss.” If you sell that position, your unrealized loss becomes a realized “harvested” loss. After selling, there are strategies to maintain your desired target allocation, and exposure in the marketplace. For example, you could sell Chevron at a loss and buy the Vanguard Energy ETF.
But be careful. If you buy the same or a “substantially identical” security within 30 days before or after you sell at a loss, your loss will be disallowed by the IRS and won’t be able to deduct the loss. This is called a “wash sale.” In the example above, if you sold Chevron shares on March 2nd and then bought them back on March 16th, you would have incurred a wash sale, negating any tax benefit. That’s true even if you are buying and selling the security in different investment accounts. We regularly do tax loss harvesting in client portfolios using the method described above and others. We’re familiar with the rules for avoiding wash sales, so coordinate with your advisor to take advantage of this tax saving opportunity and make sure it gets done right.
When you have harvested tax losses, you can net them against capital gains in the current year and future years. The maximum net capital loss you can take in any year is $3,000, which is deducted against ordinary income. Any unused capital losses are carried forward indefinitely, potentially giving you the ability to diversify, now or in the future, other positions that may have increased in value and have capital gains. Take this opportunity to make sure your portfolio is well-balanced so that you don’t have too many eggs in one basket.
When market values are lower, it can be more advantageous to give assets to others. If you are likely to exceed the estate tax exemption ($11.58MM per person in 2020), consider gifting some of those assets to your non-charitable heirs now. You will use less of your estate tax exemption than if you gifted them after the assets recovered. Instead, your heirs will benefit from the future appreciation in the assets.
One tool to reduce the future growth of your estate and transfer assets to others is a Grantor Retained Annuity Trust, or GRAT. The grantor places assets into the GRAT, which is an irrevocable trust, and receives income for a defined period. After making payments to the grantor for that defined period, any remaining assets in the trust are transferred to beneficiaries. This tool is particularly powerful for limiting the growth of taxable estates when assets are expected to grow substantially in the future. Because of the unique characteristics of GRATs, the assets can be transferred with lower estate tax consequences than if they are transferred after appreciating later. We regularly work with estate planning attorneys to implement GRATs and other estate planning strategies with clients. If you already have a GRAT, it is worth reviewing to determine whether additional actions may enhance the performance of your existing GRAT in this down market.
When you reach your “full retirement age” as defined by the Social Security Administration, you have the option to take your benefits or wait until age 70.
For every year you wait until age 70, you’ll get an 8% increase in your eventual benefits. This is a guaranteed 8% return. In today’s markets where bonds are at historically low yields, that’s a remarkable benefit.
Every situation is unique, and there are some cases in which it still makes sense to claim your Social Security early. Talk to your financial advisor about what makes the most sense for you.
As market conditions change, it is a good time to make sure that you have “stress tested” your financial plan. Do you know how your plan holds up in bear markets? What if you decide to retire during a bear market? What else do you need to plan for in these times? Consider taking a fresh look at your financial plan to make sure that the road ahead is still pointing in the right direction.
Market volatility can feel unsettling and uncertain. But by controlling what you can control, you can make sound financial decisions even in challenging times.
Please don’t hesitate to call if you’d like to talk through any of these strategies in greater detail.