Four smart planning moves to make right now

Markets continue to pose challenges in 2022 as the pullback in the S&P 500 has deepened to 22% on the year. As the duration of the downtrend continues, it has begun to wear on investors. But the moves you make now can have an outsized impact for when the market inevitably recovers. Here are four smart planning moves investors should consider today!

1. Front load 401k contributions to get more money into the market now
2. Consider IRA/Roth conversions while values are low which will lower your tax hit and reduce future RMDs
3. Fund children’s accounts, either 529 plans, custodial accounts, or both!
4. Invest in your net worth… put off the home repair, the new car, etc and consider putting that cash into the market instead.

Buying a 20% drop

For long-term investors, the case for buying stocks after a 20% decline is pretty compelling. Numerous data shows stronger than average 12-month returns following a 20% drop in the S&P 500 (see here, here, and here). Therefore, our first smart move to do right now is to front load your 401(k) contributions. If your cash flow will allow it, we recommend maxing your 401(k) so that you hit your full $20,500 contribution limit between now and August. The benefit is that you are likely to get more money into the market while it is well off its highs.

By doing this, you will forego a chunk of your near-term paychecks. However, since you’ll max out your 401(k) this summer, you’ll receive larger paychecks in the back half of the year. If you are someone who maxes out your 401(k) each year in a smooth manner (an equal amount each paycheck), consider changing your election to front load your contributions right now. The same goes for any IRA contributions; instead of waiting until year-end or next April, consider making 2022 IRA contributions now.

Consider Roth conversions or a backdoor Roths

Now is also a good time to consider converting a portion of a traditional IRA account to a Roth IRA. Such a conversion will be taxed, but with asset prices low, the tax hit is lower than it would have been six months ago. Those same low prices also potentially make earning the return needed to offset the tax hit easier to achieve. Let’s look at an example.

A couple in the $250,000 tax bracket who decides to convert $50,000 of IRA assets to a Roth IRA will be taxed at a rate of 35%. So this $50,000 conversion will trigger $17,500 in taxes (it’s recommended to cover this tax with non-converted dollars). To earn back this $17,500 the investor needs a 35% return on their $50,000. This breaks down to needing about a  6%, 3%, or 2% annualized return over the next 5, 10, or 15 years, respectively. Couples who have ample cash flow and more than 10-15 years before they retire should strongly consider such conversions.

Tax perks of a Roth IRA

Paying the upfront tax upon the conversion is annoying, but you pay it once and you’re done! Once you get that money inside a Roth IRA account, it will be tax free upon withdrawal. In addition, Roth IRAs do not have any required minimum distributions (RMDs). Therefore, you have better control of your cash flow and tax situation later in life. We see it with many of our clients in their 70s… they don’t need the money, but they are forced to take a sizable RMD and then pay taxes on it. They’d rather leave that money in their accounts, but they can’t, the government makes them take it out!

Another big perk of the Roth IRA is the rules surrounding inheritance. When someone inherits a Roth IRA, they are inheriting tax-free income. This is a very nice parting gift from a parent to their child as they will not be increasing their child’s tax bill when they pass away. If an heir inherits a Traditional IRA on the other hand, they will be required to treat distributions from the account as taxable income. If it’s a sizable IRA account, the heir could be looking at paying taxes in the 30-40% range for a number of years.

Speaking of gifts to your children…

Another smart move to make right now is to get those contributions into children (or grandchildren) accounts! (Or any loved one). If you’ve yet to make a 529 plan contribution this year, now is a good time to do it. (The reasoning is the same as the 401(k) discussion above). Also, consider automating these types of accounts so that the money that gets deposited doesn’t just sit in cash. Providers like Vanguard offer solid 529 plan options. But if your state offers a tax deduction for contributions, make sure you open a 529 plan qualified in your state.

We have a few clients who typically take advantage of the gift tax exclusion to fund custodial accounts of a minor. In this case, we encourage these clients to make these gifts now so that the money goes into the market sooner than later. If you usually make a gift at the holidays or a birthday, consider gifting early. And if you do have a custodial account for a minor, make sure you are taking advantage of tax-loss harvesting! Just because a child may not have income doesn’t mean they can’t carry forward capital losses for use against future capital gains. Smart use of tax loss harvesting and the Kiddie Tax can generate higher than normal returns for your children or grandchildren.

Invest in your net worth

It’s generally accepted that it’s better to buy stocks low versus high. The problem is that most severe stock market falls, like the one we’re seeing now, are associated with a downturn in personal wealth. This can make it difficult, (or not even possible depending on circumstances), to view the stock market decline as an opportunity. But if we take this downturn in personal wealth, and apply the same logic of “buying low” then what we need to do is clear: we need to invest in our net worth; we need to “buy low” on ourselves.

This can be very challenging… the natural inclination in a market like this is to stack as much cash as possible for fear of what may lay ahead. But over-saving can actually have a negative impact on your net worth as cash acts as an opportunity cost on your net worth over time. If you typically have 3-6 months worth of savings in an emergency fund, you may consider bumping it up to 6-12 months worth. But beyond that, weigh the benefits of funneling any extra cash into the market.

And we’re not just talking stocks either… bonds are offering their highest yields in 11 years. We know the market is stressful, and it won’t get better overnight, but using this downturn to increase your assets should have a positive impact on your long-term net worth. So if you’ve been planning a new home renovation, or a new car, or whatever… give a hard thought to putting those plans on hold for the time being. An investment in your net worth today may make those items more affordable for yourself in the future.

To recap… review 401(k) contributions and see if it makes financial sense for you to front load your contributions so more money gets in there now versus later. If you have assets in a Traditional IRA, study the benefit of converting some of those assets to a Roth IRA or doing a backdoor Roth. And if you’re investing in a young person’s future, now is a good time to re-up that investment. Lastly, and most importantly, take a complete look at your personal financial situation and see if you can afford to invest more in your net worth while its (probably) at a lower value than it was one year ago.