Wealth Strategies during a Down Market

WEALTH STRATEGIES DURING A DOWN MARKET

Even though volatility has returned over the last year, markets have weathered the storm alright thus far. Nonetheless, a more sustained downturn in the markets may occur at any moment. These declines combined with media headlines stating how the end is nigh can understandably cause the common investor to feel much angst and a sense of helplessness.  However, the prudent investor with the proper guidance and plan could potentially use a poor market to their advantage by taking an opportunistic approach and considering certain planning strategies. Our intention is never to “time the market” at Hudson Oak, however we always want to be prepared to implement smart planning when opportunities present themselves.

Below we touch upon some practical yet sophisticated solutions to turn a negative investment market into a positive overall wealth event for your financial plan.

Consider a Roth Conversion

Those with a traditional individual retirement account (IRA) consisting of securities negatively impacted by general market declines may have a unique opportunity to convert their traditional IRAs to a Roth IRA.   The value of the converted amount consisting of tax-deferred contributions will be subject to income tax.  At first glance, the logic for why someone may want to do this seems counterintuitive – why would you desire to unnecessarily accelerate recognizing income that would require paying tax?  Under a thorough analysis it may be beneficial to realize the tax impact now rather than years from now. 

For example, if a $200,000 traditional IRA consisting of entirely pre-tax deferrals declines by 20% in value to $160,000 due to a temporarily depressed market, a Roth conversion would result in $160,000 of current ordinary income recognition.  As the value of the holdings recover and many years from now are withdrawn from the Roth IRA in a qualifying manner, no tax obligation will result on distributions from the Roth. If the funds had remained in a traditional IRA, they would have resulted in ordinary income tax liability on each dollar distributed. Further, it is important to note that a conversion is not necessarily an all or nothing approach. A partial conversion of the balance stated above is possible, resulting in a smaller tax bill. A plan of systematic conversions over time may make sense, smoothing the tax hit over several years.

Also, a benefit to this converting traditional IRAs to Roth IRAs for those nearing their required beginning date for RMDs can strategically move these funds into Roth accounts - paying tax - but avoiding future required minimum distributions, allowing the funds to grow completely tax free in the Roth where they wouldn’t be if they had already been distributed. This decision usually depends on a thorough analysis where both time and future expected return of the portfolio should be carefully examined to see if moving the tax up makes sense.

This strategy fits well when an investor has a disciplined investment plan where they are invested in securities that are appropriate for their longer-term investment plans but have simply come upon tough times from a performance/valuation perspective.  It is important that this financial planning strategy be evaluated in coordination with an individual’s broader tax, investment, and financial plan.

Accelerate the Realization of Certain Equity Compensation Awards

For employees, directors, executives or start-up owners that receive equity compensation awards such as Incentive Stock Options or Nonqualified Stock Options it may be worth considering exercising a portion of those options during a market downturn.  Traditionally, options are a valuable tool for equity recipients as they can provide unique leverage, particularly if the company has a long-term positive outlook. An argument for leverage - in most, yet not all, cases - suggests that the longer you hold the option, the better the leverage over the grant price. If the market has declined temporarily however, yet the option is still comfortably in the money, exercising a portion of the options can make sense.

When an employee stock option is exercised there are income tax consequences depending on the type of option and subsequent actions of the individual.  In a basic example of Nonqulaified Stock Options, a $10 option to purchase stock of your company while it trades at $15 would result in $5 of taxable income to the option exerciser. Again, why would anyone willingly accelerate recognizing taxable income?  If that company stock was previously trading at $20, but the option holder is bullish on the company’s long-term prospects, they should view the $15 valuation as an opportunity to obtain the stock at a lower overall tax cost - both in the near-term as well as long-term when the stock is ultimately sold.  While your colleagues or the general public fears the sky may be falling, the opportunistic yet disciplined investor has a chance to take advantage of a recent, but temporary, decline in the stock’s value.

Rebalance Through Continued Dollar Cost Averaging

Basic human nature leads us to actively avoid situations that push us out of our comfort zone.  Naturally, when the broader stock market moves negatively, a common reaction is to sell out of positions and move to cash or other stores of value. Essentially, the natural reaction is to not invest more.  However difficult it may be to battle our internal dialogue on what to do when markets turn against our long-term goals, this is often the perfect time to stay true to a dollar-cost averaging plan within your broader rebalancing strategy.

Dollar cost averaging is the forced savings and investment strategy in which an investor methodically invests a set amount at set internals over the course of an investment program.  A basic comparison is for those who take part in their employer’s 401k plan.  Through payroll deductions a set amount or percentage of an employee’s pay is invested into their 401k plan.  A similar approach can be taken within an investor’s non-401k savings program. 

Through routinely contributing and investing an amount at regularly recurring intervals, the prudent investor is taking advantage of market declines by being able to purchase more shares at depressed prices than they otherwise would have been able to. Having a professional advisor in place to ensure you are diligently following this strategy and executing properly can add substantial wealth over time. An investor that dollar costs averages may have the opportunity to bring their allocation back into alignment with their longer-term goals, while again buying at lower valuations. Having a formal investment policy in place can help assure this outcome.

Rebalance Through Continued Tax Loss Harvesting

Hudson Oak’s investment philosophy does not consist of broadly selling low as prices fall, however when tax loss harvesting opportunities arise they can be a valuable way to improve tax outcomes.  Loss harvesting allows an investor to generate capital losses to offset any capital gains incurred during the tax year. In fact, an individual may be able to deduct $3,000 worth of losses in excess of their capital gains. If specific holdings have decreased in value to a loss position, it may be a chance to capture these losses while bringing the overall investment allocation back into proper alignment. There are special tax rules however that should be followed closely to ensure this strategy works effectively. For those that may have entered the markets later during the recent bull-run, this approach in particular may be valuable since their positions may not have appreciated as much yet and are closer to neutral. If there are some positions with gains and others with losses, a broader rebalancing can take place.

Make Use of Wealth Transfer Techniques

When markets temporarily decline, opportunistic individuals that are interested in transferring wealth to their loved ones can use depressed stock prices to transfer more shares.  In 2019, the annual exclusion amount for which wealth can be transferred to another individual is $15,000 per recipient without needing to file a gift tax return and utilize your lifetime estate and gift tax credit.  What this means is that if annual gifting is part of your long-term wealth plan, a security that was worth $100 meant that 150 shares/units could be gifted without any gift tax considerations.  However, a 25% decline to $75 would mean that 175 shares/units could be gifted, effectively pushing more shares to your loved ones which can ultimately benefit from the subsequent recovery in the holding’s valuation.

For more sophisticated planning needs, the use of certain trusts such as grantor retained annuity trusts (GRATs) and similar other split-interest trust arrangements can allow wealthy families to effectively transfer wealth.

Broad market declines and economic downturns can provide trying times for family wealth and our personal or professional finances. Hope is not lost however and while the common approach may range from “do-nothing” to “panic and do everything”, the right answer often lays in the middle ground. While a market bottom or declining period is never a wise time to sell if the investment strategy fits the broader portfolio construction, it can be a time for action on other fronts of your financial world.

If you are interested in learning more about putting together a plan to take advantage of specific opportunities that a down market can offer, we encourage you to contact us.

Disclosure: Hudson Oak Wealth Advisory LLC (“Hudson Oak” or “Hudson Oak Wealth”) is a registered investment adviser in the State of New Jersey. For information pertaining to Hudson Oak’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Hudson Oak. A full description of the firm’s business operations and service offerings is contained in Part 2A of Form ADV. Please read this Part 2A carefully before you invest. This article contains content that is not suitable for everyone and is limited to the dissemination of general information pertaining to Hudson Oak’s Wealth Advisory & Management, Financial Planning and Investment services. Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this presentation will come to pass. Investments involve risks and may lose value. Figures displayed within this communication are for illustrative purposes only. Nothing contained herein should be interpreted as legal, tax or accounting advice nor should it be construed as personalized Wealth Advisory & Management, Financial Planning, Tax, Investing, or other advice. For legal, tax and accounting-related matters, we recommend that you seek the advice of a qualified attorney or accountant. This article is not a substitute for personalized planning from Hudson Oak. The content is current only as of the date on which this article was written. The statements and opinions expressed are subject to change without notice based on changes in the law and other conditions.