The markets were off to a strong start in 2020, building on the impressive returns of 2019. In late February, a complete 360 happened as panic set in and COVID spread into The United States. In this episode of The Agent of Wealth Podcast, host Marc Bautis discusses why investors should focus on what they can control, including six financial strategies that could make an improvement in your life.
In this episode, you will learn:
- How rebalancing your portfolio helps you stick to your investing plan, regardless of what happens in the market.
- Why it may be a good time to consider: A 15 year mortgage, pre-paying your retirement plan, and harvesting tax losses.
- Why it’s important to understand your risk tolerance and risk needs.
- The best times to execute a Roth conversion.
- And more!
Bautis Financial: (862) 205-5000
This past month has brought on a challenging investment environment. After a great 2019 for the markets, the economy and markets were humming along and off to a strong start in 2020. However, in late February, the Corona virus started spreading outside China and the markets have been in panic mode since.
Listening to the news about the market drop and about the spread of the virus can be emotionally taxing. We can’t control the market. We can’t control the impact of the coronavirus, whether the Fed is going to lower or raise rates or if Saudi Arabia is gonna flood the market with oil. It’s important to focus on things that you can control. And on today’s show, we’re gonna talk about six strategies that you can control, and they may benefit you financially and are definitely worth exploring.
Rebalancing Your Portfolio
The first thing we’re gonna talk about is rebalancing your portfolio. And no matter what you’re trying to do with your investment portfolio, whether it’s saving for retirement, your child’s education or if you’re just saving in an investment account, you really should have a strategy on how you allocate those investments. We’ll look at a simple example. Let’s say that the right strategy is to be 50% in stocks and 50% in bonds. Over time, usually the stocks will increase in value faster than the bonds. This means that over time more of your portfolio will get allocated towards stocks. After a year, it may go from 50/50 to 60% stocks and 40% bonds. Then after a couple years after that maybe it gets up to 70% stocks and 30% bonds, and it will just keep getting bigger and bigger. You don’t even realize it but you just become more and more aggressive over time, even though you didn’t intend to do that. Rebalancing is periodically bringing that allocation back to your initial strategy. To rebalance you sell some of the things that have gone up and you purchase some of the things that have decreased in value. You might be thinking, well, if my stocks are going up, that’s great and I should just let it go. One of things that can happen and we are seeing it right now is that the market has a drop and you were too heavily invested in stocks. Emotionally, you panic and you decide to sell everything, which most likely is at the wrong time to do so. So you do want to have the correct allocation for you: whether that is conservative, aggressive, or moderate. You want to have enough risk that you can hit your goals, but also ensure that you are comfortable with the ups and downs and don’t lose sleep over it.
Here are two examples when rebalancing worked like a charm.
In December 2018 we saw a 10% market drop because of the trade war with China and the Fed raising interest rates. If you rebalanced at the end of the year or in early January, your rebalance would have most likely brought you back to your target allocation by buying more stocks and selling bonds (because the stocks dropped and bond prices went up). In the first quarter of 2019, the stock market popped back up very quickly. By purchasing more stocks at the end of 2018 you were really able to take advantage of that market increase.
Another instance where rebalancing made sense again was one year later in December of 2019. For the full year in 2019 we saw big gains in the stock market. If you rebalanced at the end of the year, the rebalance would have sold some of the stocks that increased and purchased bonds. The result is your portfolio would not have gotten hit as hard as it is now with the market drop.
Rebalancing doesn’t always work perfectly like that.. But it’s a good technique to use to make sure you stay disciplined with your investment strategy and that you’re not straying too far off your target allocations.
The second strategy we want to talk about is a Roth conversion. A Roth conversion takes pre-tax money, you’re paying the taxes on the money now, and it gets put into a Roth IRA where you’ll never pay taxes on it again, this is assuming that you meet a couple criteria in terms of when you take the money out of the account.
When you have an IRA or a retirement account there are usually two ways that they are structured. One is pre-tax and that includes your traditional IRA and your traditional 401k where you’re making pre-tax contributions and you’re getting a tax deduction in the year that you make the contribution. However, when you take the money out when you get older and retire, you’re paying ordinary income tax on your distributions. The common thought is that when you retire and you start taking money out of your retirement account you’ll be in a lower tax bracket, but a lot of times that’s not true when you factor in all of your IRA distributions, your Social Security, and any other income that you have coming in. Oftentimes you end up in a higher tax bracket during retirement.
The other option is the Roth IRA or a Roth 401k, the way this works is you’re making post tax contributions to the account. When you retire, you don’t have to pay any tax on the money taken out of the Roth IRA or Roth 401k. It’s building a tax-free retirement nestegg and has some other benefits to it. In terms of estate planning and also because you’ve paid tax on it, you are allowed a little more flexibility in utilizing the funds prior to age 59 than you are on the pre-tax version of the traditional IRA. However, by converting a Roth IRA it means you’re paying the tax right now, so you’re taking the pain now of paying tax on any amount that you convert over to a Roth. As an example, let’s say you’re in a 20% tax bracket and you want to convert $25,000 of your pre-tax IRA into a Roth. You would owe $5,000 in taxes the year that you make the contribution. You have to take into account that you are front paying some of this tax in the year you make the conversion.
There are two times where converting money into a Roth makes the most sense. The first one is in a year where your income is less and you’re going to be in a lower tax bracket. As an example, let’s say you are a business owner and your income varies month to month. One year your income is high, and the next year your income decreases. The year that your income drops is definitely an opportunity to look and see whether it makes sense to convert any of your IRA into a Roth. This is because you’re converting it and paying tax on it in a lower tax bracket than the previous year where you earned more income.
The second time where it may make sense to convert money into a Roth is the year where the value of your IRA is down. So that’s really what we’re looking at now with the market dropping. If you do have a drop in your IRA value, the amount that you’re converting is less, which is the amount that you will need to pay tax on. This translates into less tax that you would have to pay for the conversion. In the example we just looked at we were in a 20% tax bracket and converted $25,000, resulting in $5,000 worth of taxes. But let’s say the $25,000 value dropped and it’s now $20,000 that you’re converting. You will only have to pay $4,000 in taxes, so you’re saving an extra $1,000 in taxes.
Another feature with Roth conversions is that and you don’t have to convert your entire IRA. You can do partial conversions. One of the strategies I like to utilize is called, “Filling the Bucket,” which means you convert to a Roth up to the amount that would push you up into a higher tax bracket. The bucket is the tax bracket that you’re in and whatever is left over you’d look into converting that amount into your Roth IRA. We don’t know what the future tax rates will be, but we have software that can be used to run scenarios. We can model side by side the benefit of converting to a Roth IRA versus not converting, which will allow you to analyze and make your decision on whether it makes sense to convert or not.
The third strategy we’re gonna talk about is refinancing your mortgage. Interest rates have come down substantially this year, especially in the past month. I like to approach the topic on whether someone should refinance by running different scenarios to analyze what makes sense by comparing the current loan against different refinance scenarios to determine if it makes sense.
You want to take into consideration the length of the refinance. As an example if you are 5 years into a 30 year mortgage, and you decide to refinance back into a 30 year mortgage, that means you are going to have less of a monthly payment, but 5 additional years that you wouldn’t have had if you kept your original loan.
In my analysis I factor in closing costs as well as the interest you’ll pay over the life of the loan for each of the scenarios. An opportunity that arises in today’s interest rate environment is the ability to refinance from a 30 year into a 15 year mortgage. Two of my favorite things in finance are 15 year mortgages and Roth IRA’s that we just talked about converting into. 15 year mortgages have tremendous savings on the interest that you pay when compared to a 30 year. I think they give the best bang for the buck in terms of the interest that you’ll pay over the life of the loan.
I was recently looking at a scenario where someone had a $500,000 mortgage and they were looking at refinancing into either a 30 year or a 15 year. With a 30 year mortgage, their payment would be about $2300 per month. With the 15 year it would be $3300 per month. The negative of 15 year loans is that it will be more expensive each month, but over the life of the loan they would save over $200,000 of interest. And some people may be thinking I just did a refinance recently or I just purchased my home recently and it probably doesn’t make sense for me to do it again. My recommendation is to run the numbers, it may make sense.
Prepay Your Retirement Plan
The next strategy we’re gonna talk about is prepaying your retirement plan contribution. We are approaching the end of tax prep season and for most people, that means the deadline of getting your IRA contribution in for 2019. It definitely makes sense to make your IRA contribution, but another strategy you can utilize is also make your 2020 contribution now too. You don’t have to wait until next year to make your 2020 contribution. Try to forget about whether the markets are going to go down more and if it is a good time to add money to your portfolio now. By making your contribution now it gives you a full extra year of having your money in a tax advantaged account. If you do this every year it will actually add up to a significant amount of benefit by the time you retire. When you factor in that stock prices are a lot lower now than they were a month ago, it’s another reason to execute the strategy.
Harvesting Tax Losses
The next one will talk about is harvesting tax losses. We are in a scenario where there’s been a big market drop recently. The drop may have created some investments in the portfolio that the purchase price of the stock was higher than where the stock is trading at now. This is called an unrealized loss. Harvesting that loss means that you would sell the investment and purchase a different one with the proceeds. Once you sell the investment you can use the amount of the loss as a deduction on your tax return (or to offset any capital gains tax that you might owe). The IRS allows you to take a deduction of up to $3000 in losses per year.
If your losses are more than 3000 you can use them the next year, or carry them forward as many years into the future as you would like.
Here are a couple of things to note about harvesting tax losses:
- Being able to harvest tax losses is only applicable in retirement accounts. In your IRA’s or 401k’s it doesn’t matter because you are deferring having to pay tax in that account anyway.
- The losses you have to sell any of the investment that you have a loss that you want to harvest has to be sold by December 31st. It is not an April 15th tax deadline it is a calendar year deadline.
- On Episode 35 of The Agent of Wealth Podcast, I talked about a new investment strategy called Direct indexing, which automatically does tax loss harvesting for you.
Tax loss harvesting is something you can always take advantage of, but the opportunities are there more in environments like this where there’s been a market drop. With the market dropping over the past couple of weeks, it is a good opportunity to look at your investment portfolio and see if you have any opportunities to harvest losses.
Do You Have the Right Amount of Risk?
The last thing I want to talk about is your risk profile. No one likes to see your account value go down. But, it’s never a straight shot up and we all have to be comfortable with our investments. It’s normal to be worried about the markets, but if you are panicking, it probably means that you are not properly allocated in your account. I’m always preaching a risk first investment approach which has three parts:
- Understand how much risk you have in your portfolio.
- Determine how much risk you are comfortable taking.
- Correlate that with how much risk you should have to meet your financial goals.
Understanding the amount of risk you have is important because some of these investments are black boxes and are not transparent with how much risk they are taking. It is important to determine how much risk you are comfortable taking because you never want to get to the point where you sell your investments during a market drop. If you do that most likely the sale will come at market lows.
Your investment portfolio should be geared toward driving us to hit our goals. In market drops like this one the most important thing to know is am I still on track to hit my goals. There will be market drops and there will be recessions. You don’t have to take any more or less risk than you need.