What Good Can Come from Market Declines?

We’ve certainly experienced significant volatility. More may come. A downturn in the market brings opportunities to be on the watch for. When markets decline, why not take advantage of declines in your investment portfolio? Perhaps you have more wealth than you will need throughout your lifetime. Or maybe your portfolio is too concentrated in certain securities or sectors or not invested in tax-efficient holdings. Maybe a Roth IRA conversion makes sense. Now may be the time to review planning opportunities.

Realign your portfolio – Do a swap

If capital gains taxes have kept you from realigning your portfolio, a decline may be an opportune time. You could swap from one stock or mutual fund for another that is also depressed in value. This may allow you to minimize any tax impact, while not hurting yourself economically due to the lateral move. Let the rebound happen in the new holding. You might even capture a tax loss- and sleep better at night.

• Concentrated stock – Companies, even big ones, can fail or become almost worthless – a company-specific risk. We can all think of examples and stories of employees of those companies who held a weighting in company stock. If a company has some unforeseen financial difficulties – due to competition, the economy, changes in laws, the product becoming obsolete, etc. – the stock price declines and usually accompanies layoffs. Employees are left jobless with fallen portfolio values. It is common for company employees to feel so positive about the company’s stock. Many investors think this could never happen to the stock they own a concentration in. Oh, but what if?
• Sector overweighting – Another similar risk is to have too heavy a weighting in one sector of the economy, such as technology, financials, etc. What if you suddenly need that money when your sector is down?
• Swap to improve tax efficiency – Or perhaps you want to get out of actively managed mutual funds that wreak havoc on your tax situation with their annual capital gain distributions you can’t control and get into tax-efficient exchange-traded funds (ETFs) instead.

Employer Stock Options – Convert ordinary income to capital gain income

Some employer stock options are taxable as compensation when exercised based on the spread between the value of the stock price at that time and the option cost. What is the best strategy to exercise your stock options? That depends, of course.

• Exercise and Hold
  • With deflated stock prices, the income tax on the spread could be reduced by exercising when the price is down.
  • However, it may not be a good time to sell the stock at such lows to cover the option cost and income taxes. Suppose you have enough resources to pay the option cost and income taxes without jeopardizing cash reserves? Consider exercising some of your vested options and hold the stock for an anticipated rebound and potential long-term capital gain treatment – better than ordinary income tax.

Roth IRA Conversion

Conversion or partial conversion of a traditional IRA to a ROTH IRA can be advantageous for income tax and wealth transfer purposes. We’re in a low tax rate environment historically speaking, so that can make it a good time to do a Roth IRA conversion.

Market declines make it an even better opportunity to do a conversion. Converting when the IRA value is down can mean either converting more shares for the same value or converting the same number of shares for a lower conversion value. Either way, there’s leverage in a down market.

On conversion of the IRA to a Roth IRA, you essentially freeze the IRA asset’s value for income tax purposes by paying the income tax on the converted value. From that point forward, any future growth escapes income taxation, if withdrawals are qualified.

• Converting when you’re young – For a younger person, conversion can make sense for income tax purposes and to avoid future mandatory distributions that are required from a traditional IRA, enabling it to continue compounding tax-free.
• Pair with some high-deduction years – A Roth IRA conversion can make sense if you have a year with large deductions to help offset it, i.e. a business loss from doing a cost segregation or a large charitable deduction.
• Take advantage of some low tax rate years – Someone retiring might have a few lower income years before required minimum distributions start on their IRA that could push them into a higher tax bracket. A Roth IRA conversion might be a good opportunity to reduce future RMDs and tax some of the IRA balance at lower tax rates. Bonus – the balance continues to grow tax-free. That is much better than accelerating IRA withdrawals now to minimize the size and taxation of RMDs later and investing the net in a personal brokerage account whose earnings get dinged for taxes each year.
• Estate planning purposes – A conversion can also be a great estate planning strategy. Suppose after doing retirement planning projections, you realize you won’t need all those funds during your lifetime. Maybe you have a taxable estate. A Roth IRA can be a very effective vehicle for passing wealth to your heirs, especially in light of the 10-year payout under the SECURE Act for most non-spouse beneficiaries. This accelerated period for withdrawing a traditional IRA balance could push your beneficiaries into a higher tax bracket. On the other hand, Roth IRA distributions are tax-free to your heirs, making the 10-year payout a nonissue income tax-wise. By converting to a Roth IRA, you’re paying the income tax for them (gift-tax free) and leaving them a more valuable tax-free account. Additionally, the income tax you pay for the conversion reduces your estate and potential estate taxes. In the meantime, you wouldn’t be forced to take RMDs that you don’t need.

Enhanced Gifting Leverage

If you have a taxable estate, a decline may be an opportune time to make gifts. If you have a federal taxable estate and want to lock in the temporary $13,990,000 federal exclusion before it goes away at year-end (unless extended), you can transfer more units now for the same gift value. Let the eventual rebound happen in their hands and you remove future appreciation from compounding your estate. If you have a state taxable estate (over $7,160,000 for NYS), but not federal and therefore wish to preserve as much of your federal exclusion as possible, you can make a gift of the same number of shares but at a reduced gift tax value, using less of your exclusion. Either way, a significant amount of wealth can be transferred free of any gift tax. How?

• Outright gift – You can make gifts of assets directly to individuals for them to do what they want with.
• 529 Plan gift – A decline can be a good time to make a gift to a 529 plan for your child or grandchild. If they won’t need the money near-term for college, it could be a good buy opportunity and let the rebound eventually happen in the 529 plan for possible tax-free withdrawals later.
• Gift to family in trust – There are many tax and non-tax reasons to gift to heirs in trust rather than outright.
  • Irrevocable Trust – Current deflated values reduce the gift tax impact on the transfer into the trust.
  • Intentionally defective grantor trust (IDGT) – Gift and/or sale to an IDGT – You can make a gift at current low values. Or you can sell some assets to this kind of trust and take back a note. A note rather than a gift could make sense if you’ve already used your estate exemption or need the cash flow back.
  • Grantor Retained Annuity Trust (GRAT) – GRATs allow you to transfer wealth to your heirs at the end of some chosen time period while making annual payments to yourself in the meantime. The transfer to the trust is a gift. Since your heirs will not receive the assets for a while, the transfer value to the trust is frozen and discounted for gift tax purposes. This technique works best when interest rates are low (they’re relatively low now) or if you fund the trust with stock temporarily deflated in value. A low value could give the trust a growth burst if the stock rebounds in the trust, giving you leverage. If you have a large estate, this technique can work well when you’ve already locked in the high estate exclusion before it potentially goes away. The trust can even be structured in such a way to not have any gift tax impact.
• Charitable trust
  • Charitable Lead Annuity Trust (CLAT) – CLATs work similar to a GRAT where they pass wealth to your heirs at the end of some time period while making annual payments (to charity) in the meantime. The transfer to the trust is a gift that benefits from the current environment in the same way the GRAT above does. If you make generous annual cash contributions to charity, this may be a perfect opportunity to leverage those charitable contributions you already make to transfer wealth to your heirs at a discount.

Seize the opportunity when it arises.

If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.