Turning Lemons into Lemonade – Tax Strategies for Mitigating a Market Decline

The broadening economic disruption from Covid-19--combined with a shock to the oil market from an emerging price war between two of the largest global producers—delivered financial markets a figurative “punch to the face” on Monday, which continued for most of this week. The S&P 500 declined more than 16% through Thursday and was down more than 26% from its peak in late-February. Although the index recovered over 9% on Friday, it marked the first bear market in 12 years.  

While the social and economic disruptions from Covid-19 (which the WHO has now labeled a global pandemic) are sure to be severe, more widespread testing and mitigation measures will eventually bring the spread of the virus under control. Two of the first countries to experience large outbreaks of Covid-19 (China and South Korea) are now seeing a slowing of new cases, only a few months after their outbreaks were first detected. Hong Kong, Singapore, and Taiwan have all earned praise for a quick and effective public health response. These countries' authorities are demonstrating to the rest of the world that it is possible to “flatten the curve” of the outbreak, preventing a surge in cases that would exceed the health care system’s capacity.    

 All of this indicates a crisis that is likely to be measured in a period of months.   In contrast, most investors have a time horizon that extends over years—and should make investment allocation decisions consistent with that timeline.  

As we noted earlier this week, for investors who are still years away from retirement, market declines offer an opportune time to make discretionary additions to their portfolio.   For those who are already retired and drawing on their portfolio for income, a mix of both stock and bond investments gives us the flexibility to temporarily draw down more on the bond allocation, allowing the equity portion of the portfolio more time to recover.   Beyond that time-tested advice, retirees with large IRA balances have a couple more tools at their disposal to mitigate the pain of a market decline by sharing some of it with Uncle Sam.

Opportunistic Roth Conversions   

For practical purposes, funds invested in a tax-deferred (Traditional or Rollover) IRA account do not entirely belong to the account holder.  That’s because there is an embedded tax liability—distributions from the account are considered ordinary income and taxed at the investor’s marginal tax rate.  Now, investors have some discretion on when they realize this taxable income.  Often, early retirees (who have stopped working but not yet begun claiming Social Security) may have several years of modest taxable income, which temporarily puts them in a lower marginal tax bracket.  In this scenario, partial conversions of a Traditional or Rollover IRA into a Roth IRA account effectively pull forward the embedded tax liability and extinguish it at that lower marginal rate.  

Even better, an investor can time a Roth conversion to coincide with a market decline and fund it with a selected “in-kind” transfer of depreciated securities.  For example, assume you have room to recognize up to $20k of additional income from a Roth conversion in a given tax year and still be within the 12% marginal tax bracket.  You can perform this $20K conversion at any point during the tax year, but an especially opportune time to do it would be right after a significant market decline.  Imagine you had purchased $30K worth of a security in your Rollover IRA account, which, following a 33% drop, was worth only $20K.  You could then transfer these shares to a Roth account, and for tax purposes, the valuation (and taxable income) would be set on the date of transfer.   If the shares subsequently rebounded, all that incremental gain would be tax-free, since it occurred under the umbrella of the Roth IRA account.    

In-Kind Required Minimum Distributions (RMD)

As mentioned above, holders of tax-deferred IRAs have much discretion—but not complete discretion—over when they realize this income.  That’s because the government mandates that account holders commence distributions from these accounts no later than age 72 (70 ½ if you reach 70 ½ before January 1, 2020).  Here again, an in-kind distribution can offer some tax savings.  By transferring (temporarily) depreciated securities directly to a taxable account, investors can satisfy their RMD requirement without having to liquidate their shares.  The cost-basis for the shares is then re-set based on the value at the date of distribution.  Any subsequent rebound in the investment accrues as an unrealized capital gain (potentially still taxable, though likely at more favorable long-term capital gains rates)

In both examples above, investors reap an economic benefit without changing their holdings or asset allocation—just by exploiting a temporary bout of market volatility to move assets from one type of account to another.