9 Smart Planning Strategies for Down Markets

Recency bias has crept into many conversations. Recency bias says that what we see going on around us most recently weighs most heavily in our assumptions of the future. The problem is that the future has no definitive timeline. Therefore, it is best to separate markets from the economy; markets are a leading signal into bad times, but also a leading signal out of bad times. To wait until it feels comfortable means opportunity is wasted.

It is with this backdrop that I would like to introduce nine planning strategies for a down market (some of these can probably be used for a longer period). There are opportunities if you know where to look.

Planning Strategy #1 – ROTH Conversions

The reason to consider a Roth conversion in a down market is slightly different than in a stable market. I have written before about the advantage of converting part of an IRA to a Roth IRA when you believe your future tax rates (or that of your children if they will inherit the IRA) are going to be higher than the tax rates of today. For example, if you can convert part of an IRA in the 12% bracket when you would otherwise be in the 22% bracket in the future (often, people pay more taxes as they start Social Security and have to start required minimum distributions), you come out ahead in the long run. Of course, we recommend doing this only if you have the cash available to pay the tax now.

In a down market, though, the second part of this equation kicks in: Converting assets that are depressed in value so that you participate on the upside (tax-free in a Roth) can be an opportunity you don’t normally see. The tax owed (next April 15) is calculated on the amount of the conversion. However, the growth from there is not taxed, effectively lowering the bracket (how much is not known until the exact day you decide to spend the money—over a decade or more, this could be a lot). The issue is knowing when to do this since trying to time the bottom of a market is impossible. Often, when doing Roth conversions in stable markets, people will do one lump sum conversion for the year. But when markets are volatile, it might make sense to look at the total amount you want to do and divide that into multiple tranches over time—basically, a reverse dollar-cost-averaging approach.

You could decide to convert once a week, once a month, or based on some other milestone. Keep in mind, though, that while it feels like market downturns may last forever, they often can be shorter than most anticipate. It is necessary to bring your financial advisor and accountant into this discussion. Prepare a game plan, even if you don’t execute it immediately. And if you do execute this strategy, know that you can’t reverse it. So, put aside the cash that you will use for the tax bill, so you have it next year when needed.

Planning Strategy #2 – Invest Cash/Rebalance

As I mentioned, picking a bottom in a market is impossible. Don’t try. Yet putting cash to work in down markets can work to your advantage long-term. Just consider that money invested today has more of an opportunity to grow from depressed levels than money that was invested months ago at market highs. Rebalancing is one way to use a disciplined approach to investing cash. Remember back when markets were calm, and you met with your financial advisor to decide on an asset allocation that met your goals? Now is the time to adhere to that allocation. Follow your process and invest when your allocation is outside of the bands you set. Doing this will allow you to sell high (cash/bonds) and buy low (stocks).

Feel free to put more cash in if you want (e.g., even investing your required minimum distributions), but just rebalancing will add a lot of value. And if the market drops further, rebalance again.

Planning Strategy #3 – Tax Loss Harvesting

Many will still have capital gain issues by year-end. They could come from the sale of a business or property or the distributions from mutual funds. Using down markets to offset those gains is an opportunity to consider.

Taking more losses than you even need—in effect, stockpiling for the future—is also something to consider, although not always the right move. Consider that when you take a loss and reinvest it, you reset your cost basis to a lower number, and you also reset your time (long-term capital gains rates kick in after a 12-month holding period). If you might need the asset within a few years, it might not make sense. Secondly, you could potentially pay more tax longer-term if tax rates were increased on capital gains.

In taking losses, you still want to reinvest this money the same day since volatile markets can move against you if you miss just a few days, much less a month. In reinvesting, you need to follow the wash sale rule, which does not allow you to take losses if you reinvest the proceeds in a “substantially identical” security within 30 days. For example, you can’t sell an S&P 500 fund from one company and buy an S&P 500 fund from another company since both will own the same stocks. Likewise, you can’t sell in your taxable brokerage account but then buy the asset back in your IRA, as this also would trigger the wash sale rule.

Planning Strategy #4 – Lend Money to Your Children or Grandchildren

Loans to children or grandchildren can be made for many reasons. In times of need, it might be to get them through a rough patch. But just as easily, it could be to help them buy a home or start a business. Today, low-interest rates give an opportunity to lend money to your children or grandchildren, assuming the goal is to give them as good a deal as possible versus you making as much interest as possible. When you make a loan, the IRS allows you to use an applicable federal rate (AFR), which means you can lend them money at a far lower rate today than a bank would charge. The IRS breaks these loans into three categories: three years or less, three to nine years, and longer than nine years. You should discuss a loan with your attorney first so that the proper documents are put in place.

Planning Strategy #5 – Refinance Debt

While savers dislike the reduction in interest rates, it works to your advantage if you have debt. With interest rates down in a weaker economy, it is a good time to look at refinancing debt of all kinds, starting with your mortgage. The trick is in knowing that many others are thinking the same thing. Thus, based on demand, banks will often raise interest rates slightly (even daily) when they want to slow down lending flow and then lower rates when they want to speed it back up.

To account for this, you will have to be diligent in checking on rates; for many, it might just make sense to fill out paperwork and then wait (be careful about being unrealistic, though). In refinancing debt, there is sometimes a temptation to take out more debt. Resist this. I have generally found that the people who sleep better at night during economic downturns tend to have lower debt.

Planning Strategy #6 – Gift Property or Other Assets

Most people think of buying assets when they are weak, but giving them away can work to your advantage for gift and estate tax purposes. It is particularly helpful if the asset is volatile and has a chance to run back up, or it is helpful if the asset pays a lot of income and the grantor is in a higher tax bracket and doesn’t need the income.

For gifting purposes, you can gift $15,000 in 2020 per grantor, per beneficiary, without gift taxes. For example, assuming a married couple wanted to gift to their daughter and son-in-law, they could gift $60,000 (dad gifts $15,000 to his daughter and $15,000 to his son-in-law, and mom does the same).

In a weak economy, and assuming an asset has growth potential (like most stock market assets, but this could include real estate or private business shares), gifting an asset (versus cash) that is depressed and letting it bounce back over the next few years could be a great way to get under the gifting limit while also giving away part of your estate.

You could take this a step further by gifting more than the $15,000 limit. Each of us has a federal gift and estate tax exemption of $11.58 million ($23.16 million per couple). (Note, each state’s exemption is different; Minnesota is currently at $3 million per person.) This federal exemption means you can give $11.58 million away while living or at death without a gift or estate tax; you simply must file a gift tax return if you do this to use the exemption while living.

Planning Strategy #7 – Update Your Estate Plan

We are reminded by the COVID-19 lockdown that life is unpredictable. Updating your estate plan is something that can be done easily since most attorneys can do it by video conferencing; the final signing would have to be done in person probably, especially since you need a notary. But now is a great time to get your estate plan done. While wills and trusts are what everyone thinks about in updating their plan, we are also learning that having a good health care directive (and power of attorney) is equally important.

Planning Strategy #8 – Reconsider Your Risk Tolerance and Asset Allocation

In the middle of market volatility is the exact time to reconsider your risk tolerance. And then, decide to make the change in a few years. You read that correctly. It is important to take your temperature in a down market to see if you can live with the decisions you made in an up market. But it is equally important to understand that making decisions when emotion is at its highest is when most people make mistakes.

To better understand this, it is important to understand the differences in risk tolerance, risk perception, and risk capacity.

Risk Tolerance

• This is your tolerance in taking risk over a long period, sometimes decades. Risk tolerance doesn’t necessarily change for many people. That doesn’t mean you don’t worry if markets are down, but it could mean that you are more able to frame it in relation to long-term goals.

Risk Perception

• Your perception of risk can change daily. With all the data and talking heads coming at you, you might feel like the market is riskier any one day over another. Keep in mind that risk is defined in both directions, down and up. Perception of risk is an issue that traders deal with more than investors.

Risk Capacity

• Your capacity for risk is more numbers-based. If you have a lot of money and don’t overspend, your capacity to take risk might be lower. Capacity for risk can change over time—for example, if someone knows that they have a lot of money to leave for an inheritance, they might decide to take more risk to try to grow it for the next generation (or vice versa, less risk since they won’t spend it all).

In reviewing these definitions, it becomes a little clearer that risk tolerance and risk capacity can be more closely tied together when making portfolio decisions. And since they are tied to longer-term goals, it is important to make decisions outside of emotional moments. Thinking through changes you want to make to your portfolio to make it more or less risky, and tying those decisions to your capacity to withstand volatility, should be done now but implemented later. Implementing when things cool down allows you a second chance to assess whether you really want to make those changes in your life.

Planning Strategy #9 – Rerun Your Retirement Spending Plan

Having more information in life is always better than winging it when recessions come. Information can bring a sense of control, especially when you can’t control the market, economy, or the speed of your internet every day. Rerunning your retirement numbers can help you understand where the pressure points are; you might not be able to control every pressure point (such as returns or inflation), but you can get a better understanding of what you can control.

Spending is often the biggest knob you can turn in a plan, and it is completely under your control. I would also point out that if spending needs to change, often doing so over a period of a year or even several years is enough to have a positive effect when you are running a 30-year (or more) analysis. Knowing that general direction gives you something positive to focus on, and it can reassure you that the years to come will be OK.

Teamwork As with anything in life, it takes a team to move forward. Everything I mentioned above needs a team of people to help analyze and ultimately help you make good decisions for your family. Make sure your team includes a financial advisor, accountant, and attorney. But just as important, make sure your team is talking with each other. Too often, decisions get made in one area that affects another area; it is only figured out too late that someone else should have been brought into the conversation. Financial planning, when done well, is a verb. It is ongoing and constantly changing to fit the set of facts as we know them. Use this time wisely and you can benefit.

If you have questions or would like to learn more, contact Jon Meyer at jmeyer@bgmwealth.com

The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.