Lemons to Lemonade

Market instability creates planning opportunities


It’s comforting to take action in a crisis rather than feel like everything is out of control. Unfortunately, however, emotional choices tend to lead to bad outcomes. Left to our own devices, we feel more comfortable following a bull market and desperately want to get out of a bear market, thus buying high and selling low.

But as planners, there are a number of actions we can suggest to our clients that will have significant benefits and higher effectiveness when the market is lower. These actions can give clients confidence that they’ve done something, and hopefully, give them the comfort to weather the storm.

As the old saying goes, “If life deals you lemons, make lemonade.”

Personal Finance Strategies

Rebalance accounts. Rebalancing does the opposite of the psychological trap mentioned above. If a client’s stock weight has fallen more than 5 percent relative to its target, start rebuilding the position. Over time, rebalancing trades add to return while reducing risk.

Refinance mortgage. The current market volatility has pushed mortgage rates to near their all-time lows. If your clients haven’t refinanced already, it’s hard to imagine a better time. While most people opt for a traditional 30-year fixed-rate mortgage, it may be worth considering a 15-year mortgage or even a variable-rate mortgage to take advantage of the most attractive rates available.

Gift to a 529 education savings plan. Your clients can make the $13,000 annual gift when values are depressed, so that the recovery takes place in a tax-deferred account. If clients haven’t started a 529 yet, it’s a great time to open one and potentially fund five years of gifts up front. These plans aren’t restricted to your client’s own children, either: You client can create them for anyone—including grandchildren or relatives.

Income Tax Strategies

Harvest losses. Your clients could use this opportunity to sell stocks that are at a loss to offset realized capital gains. A net loss of up to $3,000 can also be used to offset ordinary income. It’s important to maintain exposure to the market in case a recovery occurs, but keep in mind the “wash sale” rule, which disqualifies the loss if your client repurchases those stocks in the next 30 days.

Sell concentrated stock positions. The tax cost of diversification is lower following the stock market’s pullback. Clients can still reinvest in a diversified portfolio and participate in a recovery.

Exercise incentive stock options (ISOs). ISOs are a type of option for which the gain can be treated as a long-term capital gain if your client holds the stock for a year after exercise. So holders should consider exercising now while the price is low. And then, they can sell in one year while the capital gains tax rate remains low. Clients who are subject to alternative minimum tax (AMT) will need to be cautious, as the gain as of Dec. 31 would be a taxable item for AMT purposes. Before exercising ISOs, your client should always consult with a professional tax advisor.

Estate Planning Strategies

Roth conversion. For clients who expect to leave a legacy to their family, there’s no better asset to leave than a Roth individual retirement account. If they’ve considered doing a Roth conversion, it’s best to do it when market values are down, which reduces the up-front tax hit. For those who’ve already done the conversion, the government allows you to have a “do-over.” If the IRA has lost value since the conversion, clients can recharacterize it back to a traditional IRA and then reconvert in 30 days. For more information on recharacterizations, see “How to Murder a 2010 Roth IRA Conversion,” by Michael J. Jones in the September 2011 issue of Trusts & Estates.

Gift to an intentionally defective grantor trust. It’s better for clients to make a gift of stock when values are depressed so that future gains take place outside of their estate.

Immunize grantor retained annuity trusts (GRATS). If your clients executed GRATs funded with stocks earlier this year, take this opportunity to “immunize the GRAT.” Substitute bonds and reroll the stocks at the lower prices into a new GRAT so that the appreciation from here is transferred to beneficiaries.

Initiate long-term wealth transfer strategies. Low interest rates make many wealth transfer strategies unusually effective. As of this writing, we project the Section 7520 rate to be 2 percent in September and the applicable federal rates to be at all-time lows. For long-term GRATs, charitable lead trusts, intra-family loans and installment sales, there’s a significant cost to waiting. For more information on these strategies, see “Making Two Years Last a Lifetime,” by Gregory D. Singer and Andrew Auchincloss in the August 2011 issue of Trusts & Estates.

Valuable Impact

Unusual times give you the opportunity to have unusually valuable impact. The more we can help clients focus on objectively valuable, long-term strategies, the less likely they’ll fall prey to the short-term risks.

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