Taking Advantage of Down Markets
Good to Know
A decorated marine combat veteran and friend of the author once compared being under enemy attack to corrections in the stock market. His advice was to “stay in your foxhole when the bombs are falling and make no sudden moves.” While many would completely agree with this Marine’s timeless advice, others would argue there could be times to take advantage of opportunities and effectively stay in the foxhole. One such circumstance revolves around falling markets; two potential opportunities are Roth IRA conversions and buying good stocks on sale.
Roth IRA Conversions
Distributions from a Traditional Deductible IRA are 100% included in your client’s federal total gross income and subject to federal income tax at rates as high as 37%. Combined federal and state income tax rates can approach 50% for high-income clients. So we have bad news and good news.
- Bad news—a $100,000 Traditional Deductible IRA converted to a Roth IRA could cost as much as $50,000 in state and federal income taxes for high-income clients.
- Good news—a Roth IRA conversion during a market correction can slash income tax costs. An example follows.
Roth IRA Conversion Example
Here’s an admittedly extreme example from the first quarter of 2020:
- Markets fell by about 35%,
- A Traditional Deductible IRA valued at $100,000 before the fall would have dropped in value to about $65,000, and
- The income tax cost of a $65,000 Roth IRA conversion for a high-income client would have been about $32.5 thousand by the end of the 1st quarter of 2020.
Here’s the potential outcome:
- Income tax savings — A Roth IRA conversion after the market fall could have saved as much as about $17.5 thousand in income tax vs. a Roth IRA conversion before the fall, and
- Preserve wealth—remain fully invested in the market, thereby preserving wealth during the recovery instead of panicking, going to cash, and locking in a painful loss.
CAVEAT: Anecdotally, the author is aware of clients who followed this path during 1Q, 2020, but each client’s goals, risk tolerance, portfolio construction, and financial situation may differ. A financial professional should consider these factors and more when considering Roth IRA conversions after a market pull-back.
Stocks On Sale
Great securities are not great buys when their prices are too high. Great securities may be “on sale” during a market pull-back. For example, an investor who put $100 thousand into the S&P 500 in late March 2020 would have doubled their money in less than one year.
Summary
If falling markets are lemons, canny financial advisors can turn them into lemonade for clients by the judicious use of the potential opportunities discussed in this article. Market corrections can present even greater wealth-building opportunities than clever tax strategies such as Roth IRA conversions. Click our CFP® Curriculum to dig deeper into the resources provided to recognize and respond appropriately to these kinds of opportunities and more.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide investment, income tax, risk management, retirement, estate, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
