A bear market is defined as a drop of 20% or more from the top
TL:DR: This is a great time to move some of your money to minimize both tax and market risk. Balance in terms of risk and taxes is key to proper portfolio construction, and Roth accounts are only one possibility.
These are certainly challenging times... First-Half FUBAR: Stocks Worst In 60 Years, Bonds & Bitcoin Worst Ever
In bear markets, the market will do everything it can to suck us in and destroy our capital. It’s what bear markets do. It’s the nature of them.
A Brief History of Bear Markets
Since 1929, the S&P 500 has suffered 14 of them.
(The true number is 15 if you include the 19.8% drop that ended on Christmas Eve 2018.)
The shortest bear market on record was the last one in the first quarter of 2020. It lasted just 11 days before finding a bottom.
The longest was from March 1937 to April 1942.
And the deepest was the 86% collapse from September 1929 to June 1932.
The average bear market lasted almost 10 months and delivered a 39% loss from the peak.
(The 2020 bear market was over in the blink of an eye, but stocks fell almost that much.)
Because no one can accurately and consistently predict bear markets, investors need to prepare for them in advance.
That doesn't mean sitting in cash, earning a negative real return on your money.
Or jumping in and out of the market. If you do that, you risk being in during corrections and out during the rallies.
You should prepare for bear markets the way I've recommended for years:
- Buy only high-quality shares.
- Spread your risk outside the stock market with precious metals, insured/indexed products, and inflation-adjusted Treasurys.
- Use a sell discipline to protect your principal and your profits.
Psychological Stages of a Bear Market
This chart from Michael Batnick of Ritholtz Wealth Management might be helpful. It shows the stages of a bear market in terms of investor psychology.
Today, the S&P 500 is down 20% from its record closing high of 4,796 on January 3. It lines up pretty well to the -20% point on this chart… and suggests we’re about half way through.
I have heard 'half way through' twice just today.
And, I've stated publicly for months we likely are in a recession already.
As we progress, we’ll see what kind of stuff the Fed is made of. It will face the ‘Decision of the Century’ – either continue to let Mr. Market do his work, cleaning up more than 20 years of irresponsible monetary policies… or go back to printing money and letting inflation rise again.
That decision will determine whether we suffer a serious bear market and recession now… or an economic, political (and social?) breakdown later.
Now, as you know, I don't try to predict; just to prepare.
The Good News
But if you have been in 'the market' (here represented by the S&P index) you are flat or up since early 2021.
It may not feel like it, but this is an opportunity....let me explain...
The current downturn in the market is actually a great time to do a Roth Conversion because of the double sale that’s going on.
The first sale involves the next four years where - due to the TCJA- we get to enjoy the lowest tax rates we are likely to see in our lifetimes. The second sale is due to the 35% drop in the stock market your assets are now at much lower values and that means the tax on a potential Roth Conversion is also 35% lower.
If you were to hypothetically convert a $1 million IRA this year, your tax bill would be approximately $299,112 or a 29% effective tax rate. If you take in the decline in the stock market of 35%, your tax bill is a little more than half. You forego giving the IRS some $140,000. (This is an example. I’m by no means suggesting to do it all this year).
If the stock market goes through a massive recovery over the next few years, having done this Roth Conversion, all of that recovery occurs in your tax-free bucket.
If the market is down 25%, your portfolio has to recover 33% to get back to where you started. If the market drops 50%, you need a 100% recovery to get back to even. Where would you prefer to have that recovery occur, in your tax-deferred or your tax-free bucket?
You have the opportunity to take advantage of a double tax sale right now. Your assets are 35% lower than they were about a few months ago and that means the cost of getting into the tax-free bucket is on sale right now as well.
No matter your age, the very best place to pay for the taxes of a Roth Conversion is out of your taxable bucket. If you have more than six months worth of expenses in your taxable bucket you have some inherent tax inefficiencies in your portfolio that can cost you hundreds of thousands of dollars over your lifetime. Let’s use our least efficient bucket to help move money into our most efficient bucket.
The Personal Economic Model
Clients will have seen this. And many of you have moved your money to safety. Good for you!
Saw a Client at the gas station yesterday. He immediately said, “so glad I moved my money to safety in December.” He didn't lose a dime this year.
For others, let me show you how this works...
The Personal Economic Model allows you to see where you are today, and helps you visualize where you want to be in the future.
First you have money coming in today through your Earned Income. The big tank is called your Lifetime Capital Potential and represents the fact that you are going to have a great deal of money flow through your hands over your working career.
Money does not sit in this tank, but continues to move into the Inflow tube where your money must then pass through the Tax Filter and allow the government to take their share of your earnings before it passes to the Current Lifestyle tube where you can spend it.
Money, once in the Current Lifestyle tube, is consumed and gone forever. The Lifestyle Regulator sits behind the Tax Filter and allows you to regulate the flow of money into your Current Lifestyle and how much you decide to pump into the Savings (SAFE) and Investment (RISK) tanks.
Also, note the red color inside the tanks. The red indicates taxes. You don't control that lever. It's bolted in during working and retirement years.
Looking at this picture, it becomes clear that you must pump money into these two tanks during your working years to have the resources that will be required to maintain your present standard of living during your retirement years; you must use the two tanks to fund your lifestyle.
How much balance do you have beween your Savings and Investment dollars to solidify your financial future?
We find most people have most of their money in the Investment (Risk) Tank, and subject to unknown (but likely higher) tax rates in the future. Just like in other areas of life, balance is important. It's important to balance these tanks, to do what we can to reduce both market and tax risk in retirement.
What I have found is that many people fail because they underestimate the risks as they approach retirement. Don’t let that be you.When nearing retirement, you don’t have the luxury of time.
So, how to balance?
There are a number of approaches to creating balance. A 'strategic rollout' means you move your money out of risk over time, to achieve a minimum-risk, minimum-tax portfolio.
Using indexing, you wouldn’t have lost a dime this year due to the plummeting stock market values.
The next 10 years are likely going to see chaotic ups and downs, as well. Don’t be a victim of volatility; use volatility to your advantage.
Indexing can give you the ability to protect your principal against loss and grow your nest egg competitively.
INDEXING = PROTECTION
Essentially, indexing insulates you from market bubbles. It gives your money a safe harbor where stormy seas of volatility can’t sink your retirement ship.
- Your money is linked to the market so that when the stock market performs well, you participate in the market gains. At the same time, if the market loses, your money is protected with a guaranteed floor.
- Your cash value will receive an indexing credit, based on the market/index that you select. When that market grows during a segment, which is commonly 12 months, your cash value will be credited with interest.
- If the market you are tied to experiences large losses, like 2022, your cash value won’t decrease due to market performance. The downside risk is eliminated because of a guaranteed floor. Because your money is not in the market, but linked to the market, and because of the guaranteed floor, it is safe and secure.
- Any gains from a previous period are locked in and protected against loss, even if the index you are tied to loses in future segments. Each and every year this resets, so gains are added to the principal and never lost due to market performance.
Two Options for Indexing
Private Reserve Account, or Life Insurance Retirement Plan:
If you are looking to minimize taxes and grow your money in a tax-advantaged environment that also can have tax-free at-retirement benefits, this is the vehicle to choose. When structured correctly and funded optimally, these policies can be very inexpensive, compared to other types of insurance and retirement methods.
When designed properly, it offers a number of surprising benefits:
No contribution limits
No income limits
No legislative risk:subject to contract law; not vagaries of tax law
Tax-free withdrawals – not limited as to age
Low interest loans with no questions asked
Liquidity, use, and control of the cash
No loss provisions.
All this with excellent growth potential: Indexed TO the market, but NO market risk.
In fact, some of these accounts have beaten the market return for 20 years.
Few people are aware of the benefits of these tools, and even fewer advisors are capable of setting them up properly. So look carefully. Now, these are insurance products; therefore they require qualification, and not everyone will be able to get them.
Fixed Indexed Annuity:
If you would rather use indexing with a product that can guarantee payments so that you never run out of money. A quality annuity will replace the bond portion of a portfolio with more performance and less risk.
Now annuities have gotten a bad rap. While we refuse to sell 99% of all annuities in the marketplace, a select few have passed our level of scrutiny.
In 2019, Dr. Michael Finke and Dr. Wade Pfau wrote a whitepaper for Principal Financial titled It’s More than Money. They said, “For retirees, it’s about more than money. Not only do income annuities provide income that can’t be outlived, they give clients peace of mind and more financial security—something you can’t put a price tag on. By understanding the benefits of using guaranteed income to build a lifestyle, and by providing a clear explanation on the efficiency of income annuities, you can give clients the information to make better choices with their retirement savings.”
And some annuities today allow a partial Roth conversion, allowing you to move not only to the Safe Tank, but also to 'get there red out'...remove the tax risk of this lifetime income stream.
Questions and Options to Consider
Thinking conversion may be the right move? Ask yourself three questions. First, when will the money be needed? If you need your IRA money immediately for living expenses, converting may not be for you. Second, what is your tax rate? If your income is lower, that may favor conversion. Third, do you have the money to pay the tax on the conversion? As mentioned, it is best to pay the conversion tax from non-IRA funds.
Not sure about converting? The good news is that conversion is not an all-or-nothing decision. You can always hedge your bets and do a partial conversion of your traditional IRA during this low tax window.
Many people have a 60/40 bond/stock portfolio. What about pulling out of the bonds, which actually may be up at this time, but are subject to risk of the upcoming inflationary environment? You can’t just print anywhere from $4 trillion to $7 trillion in new money and not expect that it won’t damage the value of your buying power. (we just lived through the worst start to a year for bonds in history, as interest rates rise).
Or, you can move only a portion into a PRA and an annuity. Or consider a mix. Everyone's situation is different.
Is Conversion Right for You?
Should everybody convert? No, of course not. Conversion is not one size fits all. Also, remember that Roth conversions are now irrevocable. There is no more recharacterization or the ability to undo a conversion. This means you must be very sure before you go ahead with the transaction. Are you a good candidate? Is now the time for your conversion?
Professional advice is more valuable than ever. The best way to find out what is right for you is to discuss conversion options with a knowledgeable financial advisor…one who will look at all the possibilities; not only those that are market-based. Look for one who understands not only the proper use of the tools; but also how to minimize taxes and fees – now, and in the future.
If you want to get into the zero percent tax bracket, you have a huge opportunity right now. The market will likely recover at some point in the future, and that means there are a number of great deals to be had right now. Ideally, your assets will be able to recover in the tax-free bucket and there is a big opportunity to do so in this market downturn.