Let’s get one thing out of the way right at the top: it feels lousy when the stock market goes down. No matter how many times we tell ourselves that declines are temporary and losses don’t become permanent until we sell, it still stinks when your portfolio is worth less than it was before.
But market declines can sometimes present long-term financial planning opportunities. Any of the techniques described below will result in positive outcomes when the market eventually resumes its historical upward trend.
The concept of rebalancing is pretty simple. Start with a target portfolio allocation (e.g., 60% stocks, 40% bonds), and when the portfolio periodically deviates from that target make whatever buys or sells are necessary to bring things back in line.
Rebalancing back to a target allocation is usually more of a risk reduction technique. Because the stock market tends to go up over most time periods, more often than not rebalancing leads to sales of stocks to purchase less volatile bonds. But during periods of stock market declines, the opposite is true: rebalancing results in selling bonds (which have probably held their value) to purchase stocks that have temporarily declined in price.
Rebalancing can also take place within a broad asset class like “stocks”, not just between asset classes. For example, large US stocks (as measured by the S&P 500 Index) have been up over the past two years, while international and emerging market stocks have gone the other direction. Accordingly, some folks might keep their total stock allocation the same but rebalance some funds away from large US stocks and towards other kinds of stocks with poor recent performance.
Tax Loss Harvesting
If holdings in taxable accounts have declined to the point when they are worth less than their original purchase price, that’s an opportunity! You can sell those holdings and realize the loss, and then use that loss to offset gains elsewhere, either from other sales or year-end mutual fund distributions.
To the extent that losses in any year exceed gains, you can use up to $3,000 of those losses to reduce other income for tax purposes. Any remaining losses can then be carried forward to the next year, when the process repeats. This will continue until all of the losses are used up; there’s no deadline at which point the losses expire.
When realizing losses, it’s important to avoid the wash sale rules, which basically state that a security can’t be sold at a loss and then immediately repurchased. If that happens, you don’t get to realize the loss. To avoid a wash sale, wait 30 days to buy the original security back without triggering a wash sale.
When Woodward Financial Advisors harvests losses for clients, we make sure that we have an appropriate substitute to replace the fund or holding that we sell, since we don’t want clients sitting in cash. We look for mutual funds or exchange traded funds (ETFs) that are similar enough to what we’ve sold to capture the return of the asset class, but aren’t so similar that the IRS would consider them essentially the same. For example, we can’t sell the Vanguard 500 Index Fund (VFINX) at a loss and then buy the Fidelity Spartan 500 Index Fund (FUSEX). That would effectively constitute a wash sale, since both funds track the same index. But we could buy the iShares Russell 1000 (IWB) and still broadly track large US stocks.
A Roth conversion is when someone converts assets held in a Traditional IRA into a Roth IRA. Unlike Traditional IRAs, Roth IRAs don’t have Required Minimum Distributions that start the year the account holder turns 70 ½. Additionally, assuming that the account has been open for at least 5 years, distributions from Roth IRAs are free from federal or state income tax. Accordingly, for folks who might be in higher income tax brackets in retirement, Roth IRAs can be attractive relative to Traditional IRAs.
As with most other distributions from a Traditional IRA, a Roth conversion is a taxable event. For that reason, we often try to make conversions during low income years for clients.
A market decline presents an opportunity to convert an asset that has temporarily decreased in value from a Traditional IRA into a Roth IRA, pay a lower amount of income tax upon the conversion, and then enjoy the eventual appreciation of that asset inside an account where there won’t be any taxable gains in the future.
Market declines don’t last forever, even though it might feel like that at the time. Working with a financial planner can help folks take advantage of the opportunities presented by these temporary declines. Let us know if we can help you.