When the Market Gives You Lemons…

Financial advisors are known to wear many hats. In years like 2022, I find myself practicing psychology as much as financial and investment planning. Money is emotional, and when stocks and bonds are falling in price it invokes a lot of stress and anxiety. Decisions made under duress rarely work out well, and I try to remind clients that the investment strategy that we put into place was designed for the inevitable sell-off. While rash decisions are ill advised, doing nothing can also be a missed opportunity.

Another hat I found myself wearing often this year was one of a young lemonade stand entrepreneur, attempting to turn a sour set of market events into something potentially sweet and constructive. In this article, I outline a few ways you can turn the lemons in your portfolio into lemonade.

Tax Loss Harvesting: With the recent market rally from June lows, now is a great time to evaluate the investments that haven’t done as well this year. If they no longer have a place in your portfolio, selling those investments for a loss can offset future capital gains in better performing portfolio investments. The proceeds from the tax loss sale can go into a similar investment but not a “substantially identical” one – e.g. selling Apple at a loss and buying Microsoft is okay, selling the Vanguard S&P 500 fund and buying the iShares S&P 500 fund is not.

If you would like to continue holding the investment at a loss for the long term, you can reverse the order of the transactions – buy more shares now and sell the higher basis lot after 30 days to harvest the loss. This allows you to stay in the market.

Most investors look primarily at their equity holdings for tax loss harvesting. With the bond sell off this year, you might have some fixed income positions that are underwater in your portfolio. These may be candidates for tax loss harvesting, but the math is a little trickier. You would need enough of a yield increase on the replacement bond to make up for the harvested loss. One strategy we successfully implemented in a few instances was selling corporate bonds at a loss and replacing with higher coupon, longer dated municipal bonds. This strategy only works if the tax-equivalent yield on the municipal bonds is higher than the taxable corporate bond yield. You will want to discuss this strategy with your West Financial relationship manager to determine if it makes sense in your tax situation. 

Roth Conversions:  Making a Roth conversion after a market sell-off can be advantageous. Roth IRAs are tax free vehicles, so the eventual market recovery on the converted amount will be tax free growth. Keep in mind that the market environment shouldn’t be the sole determinant to making a Roth conversion, as my colleague Victoria Henry discussed in a recent article (To Roth or Not to Roth).

Gifting to Heirs/Estate Planning: Gifting to children and establishing irrevocable trusts following a market sell-off can be advantageous for the same reasons as a Roth conversion. If you have an estate tax issue, the growth from an eventual market recovery on the gifted assets will be out of your estate.    

If estate taxes are not a concern, there are other reasons to make gifts after a sell-off. Chances are that your children are in a much lower tax bracket than you, especially if they are just starting out in their careers. Therefore, the tax impact on the sale of gifted securities with market appreciation will be lower than if you were to sell the shares and realize those gains, yourself, in order to make a cash gift.

As with the Roth conversions, the decision to make gifts is a complicated one and the current market conditions are just one factor to consider (i.e. kiddie tax rules explained in The Kids Eat Free article on westfinancial.com).

I hope these suggestions help you to take some constructive actions in your portfolios – and if you had any lemonade stand entrepreneurs in your family this summer, let’s talk about Roth contributions for them! 

Meet Matt Cohen, CFP^®, CIMA^® »

Read the Financial Planning Focus August 2022:

• "School Daze" by Cheryl Langston, CFP^® »
• "Understanding Your Credit Score (Part II)" by Matt Weinberg and Toni Majoy, Sandy Spring Bank »
• "The Millennial's Guide to Budgeting" by Rick Gibson, CFP^® »

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