Whether markets are going up or going down, periods of movement are always opportunities to do some portfolio maintenance. With declines in both stock and bond markets so far this year, now is a good time to review the “down market” maintenance checklist.
As you review your portfolio, remember that the best way to achieve financial success is to stay invested. Despite the market downturn and current concerns over the war in Ukraine, lingering COVID-related supply chain snarls, global inflation, and rising interest rates, we know that stock markets increase in value over the long term. You can use periodic down-market episodes to your advantage and get set up for the next upswing.
Here are five ways to take advantage of market downturns:
1. Tax-loss harvesting
The classic tax-related move to make during market downturns is tax-loss harvesting. With this process, you sell securities (mutual funds, exchange-traded funds, stocks, bonds, etc.) whose value is less than what you paid for them, and thereby realize a taxable loss. Realized losses from tax-loss harvesting can then be used to offset (reduce) capital gains you have in your investment portfolio this year, or offset gains from other assets you sold or plan to sell later this year, such as company stock (e.g., shares you hold from stock options or restricted stock unit [RSU] shares) or your home. If you don’t have other gains to offset losses against, you can deduct up to $3,000 of losses per year on your tax return, and any unused losses rollover so you can use them in future years.
Tax-loss harvesting is a three-step process. First, you sell the securities that are down to realize the loss for tax purposes. Second, because you want to remain invested, you buy back securities that are similar, but not identical to, the securities you just sold. This way your investment portfolio will continue to perform much the same. Third, to avoid having your realized loss nullified by the Internal Revenue Service wash sale rule, after 30 days you sell the securities you purchased, and buy back the original securities that you prefer to hold.
Using tax-loss harvesting, you can create capital losses that will reduce your income tax this year or in future years, and you keep yourself invested to avoid missing out on a fast-moving market recovery.
2. Restructure your portfolio
This is one of my personal favorites, particularly for taxable accounts that have accumulated substantial gains over the years. With taxable accounts such as trust, joint, and individual brokerage accounts, selling securities that have appreciated results in capital gain on your tax return, and a bigger tax bill. Because of that problem, it can be difficult to move out of securities you have held for some time that are no longer your first choice and into securities you like better. You can get stuck in securities you don’t like as much simply to avoid paying tax. During a market downturn, though, you have an opportunity to make a change at a lower tax cost. You can sell the securities that are no longer your first choice and buy the securities you prefer. You will still create some tax, but it will be less than at the market’s peak. Once you’ve made the change, you’re set up for the next big market advance, invested in the securities you think will perform better. You might change just a few or many securities depending on the needs in your portfolio and your specific tax situation. The Great Recession of 2008–09 and the COVID crash of 2020 both provided good opportunities for portfolio restructuring at lower tax cost.
3. Change mutual funds to ETFs
Also in taxable accounts where capital gains are a concern, you can use a downturn to make a wholesale switch from one type of fund to another. The case for using exchange traded funds (ETFs) instead of mutual funds is becoming stronger as large brokerage firms drop their transaction fees on them. At most brokerage firms, ETF trades are now free. Coupled with their inherent tax efficiency and typically lower expense ratios than equivalent mutual funds, swapping out some or all remaining mutual funds in your portfolio for ETFs during a downturn, when tax cost is lower, is an idea worth considering.
4. Reducing concentrated positions
If you’re holding a concentrated position in a single security—for example, shares you are holding as a result of exercising employee stock options—a downturn can be a great time to reduce your concentration and move some of that money into your well-diversified retirement portfolio. There is no standard definition of a concentrated position, but as a way to think about it, if more than 50% of your net worth is tied up in one stock, you’re most likely overconcentrated. Many people would be overconcentrated with 25% or even less of their net worth invested in one stock. If you find yourself holding a concentrated position, don’t let a good downturn go to waste—take the opportunity to sell some of that single stock at a lower tax cost and move it into a diversified portfolio that can grow with less volatility for years to come.
5. Roth IRA conversion
Another all-time classic financial planning opportunity during stock market downturns that’s worth repeating is the IRA to Roth IRA conversion. With a “Roth conversion,” you take money from your IRA account and put it into your Roth IRA account where it can grow and be withdrawn tax-free after age 59½. If you convert some or all of your IRA to a Roth IRA during a downturn, the money you put into the Roth IRA has the opportunity to grow during the next stock market upswing, and you wind up with more money in the tax-free bucket.
Roth conversions are not right for everyone. When you withdraw from an IRA account in retirement, the money that comes out is taxable to you at ordinary income tax rates; it’s important to remember that the same tax treatment applies to a Roth conversion—when you take money out of your IRA to put it into your Roth IRA, you are taxed on the money you take out of the IRA at ordinary income tax rates. If you’re in a high tax bracket now, Roth conversions can be costly.
Whether it makes sense for you, and if so, how much money you should convert from your IRA to a Roth IRA, depends on several factors, including future tax rates, your future income, how much you plan to withdraw each year, and the rate of return you earn on your investments. Generally, if you expect your income tax rate to be the same or higher when you begin taking withdrawals from your IRA account, and you have many years before you begin withdrawals, Roth conversion may make sense. If a Roth conversion does make sense for you, then completing it during a downturn can make it even more valuable for you.
The truth is market downturns can affect us emotionally. They don’t feel great, especially because we’re wired to feel market losses more powerfully than market gains. It can be helpful to remember that “this too shall pass” and put your anxious energy to good use by making productive changes to your investments. Use market downturns to position yourself and your investments for better performance when markets recover and continue their inevitable climb higher.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’re concerned about recent market fluctuations and would like a second opinion on your investments, schedule a complimentary consultation.
