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If you’ve been an investor in the market over time, you’ve hopefully seen the power of compounding interest within your account(s). The stock market has offered long-term growth over long time horizons, which most investors have been able to reap the rewards of.
But the stock market has also been prone to corrections. These corrections have varied in length, severity, and cause. But one thing that is common throughout its history is it has rebounded.
While there is no guarantee that this will continue each and every time, if history is our guide, the stock market will continue to have its ups and downs.
A Risky Strategy
It’s not uncommon to hear individuals predict the next market crash. While some may be right (The movie, The Big Short comes to mind), there are plenty of examples of sensationalism.
Rather than trying to predict when a stock or the stock market will go up or down, we feel it a better strategy to accept the realities of the market for what they are – they are unpredictable. But rather than focusing on factors outside your control, we want to focus on 6 factors within your control.
Instead of being reactionary and panic, we believe in being reactionary and opportunistic. These strategies should be considered when the market goes down, and can create opportunities for you and your long-term financial plan.
1. Tax-Loss Harvesting
What does it apply to: Non-qualified brokerage accounts
When a holding within an after-tax account (commonly referred to as “non-qualified” account), experiences a loss, it generally means you may have lost some of your principle. This isn’t a good thing for investors, and we certainly don’t strive to see this.
However, in down market environments, this can be a common occurrence.
You are generally presented with 2 options, cut your losses and sell, or hold the asset and hope for a recovery.
One strategy that could offer tax savings though is tax-loss harvesting.
When you sell these investments at a loss, you can use those losses to offset capital gains, which are taxed at capital gains rates.
If your losses exceed your gains, you can use up to $3,000 of the excess loss to offset ordinary income, such as earned income, pre-tax IRA withdrawals, or interest.
Any remaining losses can be carried forward to offset future gains, making it a valuable tool for managing taxes over time.
In the event you sell your underperforming assets, it’s best to be diligent to avoid a “wash sale.” This prevents you from deducting losses if you buy the same or a substantially identical asset 30 days before or after the sale.
2. Roth Conversions
What does this apply to: Pre-Tax Retirement Accounts and Roth Accounts
We’ve discussed the ideas of Roth Conversions at length. But we feel one of the most advantageous times to complete a Roth Conversion is when the market is down.
The process involves converting pre-tax assets to Roth assets, meaning the funds are recharacterized from pre-tax to after-tax. The tax due from the Conversion is paid in the year the conversion takes place.
But the value of this conversion is had assuming the market grows back to its previous high.
Let’s take a look at a recent example:
Donald Donaldson has a Traditional IRA of $500,000 in early 2020.
He’s invested solely in the S&P500 index, which experienced a sudden 34% drop in March 2020.
Donald converts $100,000 of his Traditional IRA into a Roth IRA during the market bottom of 34%.
Donald is in the 22% tax bracket, so he pays income tax on the $100,000 ($22,000 of tax due).
The market recovered quickly in 2020, gaining roughly 70% by the end of 2020.
The $100,000 that Donald converted into the Roth IRA has gone from $100,000 to $170,000. Assuming Donald takes a qualified distribution from the account, the $70,000 growth is completely tax-free! Better yet, if he continues to let the account grow, any further growth is tax-free (again, assuming the withdrawal is qualified).
This is a great example of buying a tax-favored account at a low.
We’ve previously discussed a major risk for retirees – the sequence of returns risk. While an account may average 6-8% over a 5, 10, or 30 year time horizon, there is no guarantee that will occur each year.
It’s important to distinguish the risk involved in each of your accounts. If your account that has stock-based assets has taken a significant decline, it may be prudent to halt withdrawals from that account temporarily.
Rather, it may be to your benefit to withdraw from an asset that is not correlated with the market.
This can be a number of different asset classes, whether it be cash, bonds, or other fixed assets.
This asset class will likely not see the same growth you will notice in the years in which the market rises, but typically, these non-correlated assets are held as insurance for when the market does correct.
By creating an account that is utilized for the negative times, you can rest assured that your market-based accounts will not suffer further due to necessary withdrawals.
4. Creating a Withdrawal Strategy from Investment Accounts
We’ve also previously discussed a retirement withdrawal strategy that is dynamic and reactionary. This strategy, known as a Guardrails withdrawal strategy, allows for more enjoyment when the market (and your portfolio) is up, but a scaling back when the market (and your portfolio) is down.
Creating parameters for what this would look like is where the work is involved. Understanding that the accounts will fluctuate is a given – it’s how you plan to utilize them as income that allows for peace of mind.
This is an example of a Guardrails Strategy:
As you can see, if the account does drop by more than 10%, this investor has created parameters in which he/she would lower monthly income.
This obviously would affect lifestyle, as no one enjoys taking a pay cut.
However, if you can structure your retirement budget as such that your essential expenses are covered regardless of the paycheck, and leaving room for some discretionary expenses, you can scale back your income to preserve the account’s capital, while also not experiencing a drastic lifestyle shift.
5. Review and Adjust Retirement Spending
It’s always a good idea to create a budget that allows for consistent positive cash flow. However, in retirement, a market correction could cause a temporary decrease of inflows.
By regularly evaluating your retirement spending, you can make sure you’re covering your essential needs, doing the things you enjoy, and not worrying about what is happening in the markets.
I cannot think of a retiree who is happy who is riding the ups and downs of the market on a regular basis. The purpose of retirement is to find enjoyment and peace – despite the outside noise.
By creating a budget, and sticking to it, along with a sound income plan, you can make sure that you are living your best retirement despite market downturns.
If you need help finding, or completing a retirement budget, we have one available here, completely free.
6. Stay Flexible with Your Retirement Plans
Keeping an open mind during market downturns can also play to your benefit. While some individuals may not see work as an option, others may still find some enjoyment in it.
If your retirement plans include higher spending, or perhaps you have not quite saved enough to support that lifestyle, you may need to consider additional years of work or part-time work, specifically if your market based accounts are down.
This, in combination with developing a strategy for Social Security or a pension you may be entitled to, can allow for a buffer in the event of a down market.
This may only be applicable if you have not saved enough to support your current lifestyle and we experience a severe downturn and/or years of a prolonged downturn.
Planning Solves This
Instead of worrying about the market going up or down, it’s best to accept it as an inevitability. While we have no way of knowing if we are to experience a sudden drop, followed by a sudden rise (2020 COVID crash), or an extended period of market decline (The Tech Wreck of the early 2000’s), or the steep drop and sluggish rise of the 2008 Great Recession, we know market corrections will occur.
But by establishing a strategy to combat down years, while also being able to enjoy your wealth in the good years, you can live your best retirement on your own terms, regardless of outside noise.