It’s best to have a market downturn plan in place before the downturn hits with all its “fears and uncertainties,” says Greg Will, a financial adviser from Frederick, Maryland. “If you already have a plan and you just pull the trigger, you’ll have a much better success rate.”

Even if you didn’t anticipate the recession, 2020’s brief but sharp downturn at the start of the Covid-19 pandemic underscores the importance of being ready for a rebound. S&P 500 stocks fell about a third in February and March, then climbed about 75% over the next 12 months, and prepared investors were able to capitalize on the decline and ride the rebound.

Roth conversions

Say you’re already planning to do a Roth conversion in 2020, moving money from a tax-deferred individual retirement account to a tax-free Roth account. The money moved in this maneuver is taxed as ordinary income. If you kept your cool and made the switch at the low of the 2020 decline, you would have paid a third less tax because the transferred shares had lost value. And when those stocks skyrocketed after that inside the Roth, all those gains would have been tax-free.

Will says he had a high-income client who saved about $70,000 in federal and state taxes by doing a Roth conversion during the pandemic downturn. Shares that were worth $400,000 were suddenly worth $250,000, reducing the tax bill of the conversion. Moreover, he did not have to pay taxes on the transaction until the following year when all of his investments, including those used to pay the conversion tax bill, had already rebounded.

You shouldn’t do a Roth conversion during a market downturn unless it makes sense for you to do so anyway, advisers and accountants say. Generally, you want to make them when you pay a lower marginal tax rate now than in the future. You earn by paying the taxes now and letting the money grow tax-free in a Roth account, rather than keeping the money in a tax-deferred account and paying higher taxes when you withdraw the money at a later date.

Retirees who live off their savings and haven’t started collecting Social Security or collecting the required minimum distributions from their tax-deferred accounts are often in low tax brackets for a few years and may qualify for a conversion. Roth, says Bill Reichenstein, research manager at Social Security Solutions.

By withdrawing money from tax-deferred accounts, they will also reduce their required minimum distributions at age 72. Reichenstein’s remarks.

Where the money comes from to pay taxes for Roth conversions is important. If you need to sell additional shares in your tax-deferred account to pay taxes on the converted shares, converting before or after a market drop is usually a washout, advisers say. You’ll owe less taxes, but the value of the stocks you use to pay for them has probably fallen as well. One exception: St. Louis accountant Mike Piper says you’ll come out on top in a market decline if converting a lower stock value and paying less tax keeps you in a bracket lower tax.

In contrast, people who use the after-tax money to pay the tax from a Roth conversion almost always come out ahead by converting after a market downturn, Piper says. If they use cash, they spend less to pay the tax bill. If they use shares to pay tax, there will be tax savings. Either they will pay less capital gains (if the stock is still worth more than their cost basis) or they will create a larger tax loss (if it is worth less than their cost basis).

“In either case, from a tax standpoint, you come out ahead of a market decline,” he says.

Tax collection

For investors with large taxable accounts, market downturns are great opportunities to create tax losses whether or not they make Roth conversions. Say you buy $100,000 of an S&P 500 index fund and it immediately drops 25%. You sell your shares for $75,000 and recognize a tax loss of $25,000. You can use this loss to offset gains or deduct $3,000 per year on your tax return until exhausted.

It is important to note, however, that the Internal Revenue Service’s fictitious sale rule prohibits you from redeeming the same investment within 30 days and claiming a tax loss. Assuming you don’t want to be out of the market for a month and miss a bounce, you can take the $75,000 and buy a Russell 1000 index fund, which has almost the same performance as an S&P index fund but is different enough so as not to violate the wash-sell rule, accountants say.

You can create tax losses even more easily with individual securities, which are more volatile than large stock indices.

Houston financial adviser and accountant Scott Bishop said he persuaded a client late last year to sell losing positions in

AT&T
,

Interactive Platoon
,

Beyond meat

ViacomCBS
,

and a clean energy exchange-traded fund. His client loved companies and wanted to hold stocks until they bounced back. But Bishop encouraged him to sell and create a loss that will reduce his 2021 tax bill by $50,000.

The adviser says he told the client, “Unless you think they’ll be back in the next 30 days, I can find other stocks and we can come back to those companies later.” To replace AT&T and ViacomCBS, Bishop bought three telecommunications and media stocks. Beyond Meat and Peloton were harder to replicate. Bishop bought shares in three health food makers to replace Beyond Meat and shares in two sporting goods companies to replace Peloton. To replace the ETF, he bought another clean energy ETF.

“We tried to pick different stocks in the same sector with similar correlation because he was worried about missing the bounce,” says Bishop.

Rebalancing

Another way to emerge victorious from a market decline is available to almost everyone: rebalancing. Suppose you have a stock allocation of 60% and after a severe market decline it has fallen to 50%. You buy enough beaten shares to bring it down to 60%. When stocks rebound, you can rebalance again and you will have increased your returns. Richard Faw, a financial adviser from Philadelphia, was rebalancing almost daily for his clients during the stock market crash of 2020.

“There are no free lunches, but if there’s anything close to that, it’s rebalancing,” he says. “If the stock goes down, you buy more stock. If the stock goes down again, you buy more. If the stock goes up, you rebalance again and sell it.

A drop in stocks is also a great time to increase your stock allocation if you were planning on doing so anyway, says Marianela Collado, a financial adviser from Plantation, Florida.

“If you have money on the sidelines because you’re waiting for the perfect moment,” she says, “investing during a market downturn will yield the best results.”

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