Let’s face it, bear markets are no fun.
When all is well in the stock market, we often tell clients that we don’t have a crystal ball, but one thing that we can guarantee is that stock markets will crash at some point. In fact, depending on how old you are, or how many years you think you have left, it will probably crash at least a few more times in your lifetime. It’s an unavoidable part of investing in stock markets. Even though you may fully understand this, let’s face it, bear markets are no fun. Indeed, they can be outright scary.
The best strategy for dealing with bear markets is to have a plan before they happen. At Navigoe, that plan entails the following:
- Maintain broad global diversification to mitigate the risk of a crash occurring in a single country, sector or company,
- Hold enough fixed income assets to reduce volatility, and provide liquidity for cash flow needs,
- Continue to implement rebalancing in a systematic manner, and
- Take advantage of any tax related opportunities that arise due to the bear market.
What are the tax opportunities that arise in a bear market?
Tax Loss Harvesting
In the midst of a market downturn, some of your funds will be at prices lower than what you originally paid. You can sell those funds, realizing the losses for tax purposes. Those losses can be used to offset capital gains, reducing or eliminating your tax liability on anything you sold at a profit. After offsetting gains, if you still have losses remaining, you can use $3,000 of those losses to offset ordinary taxable income. Any losses remaining after that can be carried forward to offset future gains and/or continue to use $3,000 against ordinary income each year.
After selling your funds at losses, you can’t simply buy the same fund back again. The IRS has a rule called the “wash sale” which says that you lose the benefit of tax losses if you buy the same or a substantially similar security (which isn’t well defined) within 30 days of the sale. A common strategy is to sell the fund, realizing a loss, and immediately buying another fund that will deliver similar market exposure so that your intended allocation remains intact.
A bear market also provides you with an opportunity to complete a partial or full Roth conversion at lower asset values. Roth conversions are typically done by transferring securities in kind from your IRA to your Roth IRA, meaning that you can convert more shares at lower prices for the same tax cost. Additionally, future growth will occur tax-free in your Roth IRA.
Based on your taxable income this year, you determined that it makes sense to convert $100,000 from your IRA to your Roth. If Fund XYZ was trading at $20 per share prior to the bear market, you would have been able to convert 5,000 shares, on which you would add $100,000 to your taxable income. After the market decline, Fund XYZ is now trading at $10 per share. You are now able to convert 10,000 shares for the same tax cost. If Fund XYZ fully recovers, you will have $200,000 worth of shares in your Roth, tax-free.
Another recent development to consider is that the CARES Act waived IRA Required Minimum Distributions for 2020. Most retirees withdraw the amount of the RMD or more because they need the money for current living expenses. However, if you have been taking your RMD because it is required, not because you need it, or you have other sources of income that you can draw on instead, you should consider halting your IRA distributions. Instead you can use this opportunity to convert that amount into a Roth IRA.
IRA, HSA, Retirement Plan Contribution
Just as it is advantageous to shift assets from your IRA to your Roth for future tax free growth, this may also be an ideal time to make your IRA, Health Savings Account (HSA), or retirement plan contributions. The CARES Act also pushed tax day from April 15 to July 15. Along with this, the deadline for 2019 IRA, Roth IRA, and HSA contributions was also extended to July 15.
This contribution deadline date notwithstanding, the bear market provides an opportunity to make contributions at low market prices where they presumably have an increased opportunity for future tax-advantaged growth.
Diversify A Concentrated Position
You have probably heard that when it comes to investing, you shouldn’t put all of your eggs in one basket. However, some investors have a disproportionately high allocation to a single stock. This might be the result of a gift, a fortuitous stock pick, or most commonly company shares received as options, grants, or other stock based compensation. Before the bear market, selling the shares might have resulted in a substantial tax bill, causing the investor to retain the concentrated position despite the heightened risk. However, selling those shares in a down market might allow the investor to diversify their portfolio with a reduced tax bill.
We’re Here to Help
If you have any questions or would like to discuss how these strategies may or may not apply to your situation, we are happy to help. Please know that we are here for you.