Monday, October 27, 2008


into the market, not off the ledge:
How to take advantage of a sale

During times of wild and excessive swings of the stock market, investors have two choices: run and hide (go to cash or CDs), or take advantage of the situation. The run-and-hide approach can permanatize your losses, and furthermore requires you to time your re-entry. There are a few who think this is the end (although I reject the notion that Rock Financial has the ability to cause the end of the world). Under the doomsday scenario, you are betting on the end of the world, but since you can’t collect from anyone if you win, you win nothing. Thus, this nasty and ugly mess is likely to be temporary (temporary is an ethereal term, and could mean three quarters to three years). Notwithstanding the time frame to some semblance or recovery in prices, this market presents opportunities. Assets are on sale.

If you landed on earth today with cash, you’d find that houses are cheap; stocks are almost half off (more in many cases); interest rates are low, and oil prices have been reduced by half, all in a year’s time. There is a big sale going on. Think of it this way: if the Dow goes back to where it was in October of 2007 (back when real estate was higher, interest rates were higher, and gas was higher), you’d make 80-100%. If you want to take advantage of the sale, here are some of our ideas:

Tax-free returns, part one: Roth IRA contributions. We like Roth IRAs; they’re a virtually perfect vehicle for accumulation. You put after-tax money into a Roth, and your withdrawals, including any appreciation and income, are tax-free. Roth IRAs do not have required minimum distributions at age 70 ½ like a conventional IRA. If tax rates rise (which we think they will), Roth IRAs provide a way to get a shift in tax brackets. In addition, Roth IRAs have a built in superiority of providing growth on the taxes paid on the contribution. It goes like this: suppose you contribute $5,000 to a conventional IRA or 401(k). You get a $5,000 deposit, plus $1,250 in tax savings (assuming you’re in the 25% bracket). Let’s assume the deposit doubles (which it probably will, although we don’t know when) to $10,000. When you withdraw the money, you’ll pay $2,500 in taxes, netting you $7,500. If you made the same contribution to a Roth, you’d have a $5,000 deposit and a $10,000 balance, with no taxes. You would however, have to pay taxes up front on the Roth contribution (on the earnings) of about $1,667. The Roth allows you to keep the compounding on the taxes you would have paid upon withdrawal.

The Catch: Roth IRAs are great, but they have rules. First, you can only make contributions to a Roth if you have earned income, like wages or self-employment income. If you’re married, only one spouse needs to have earned income. You’re limited in your contributions to a Roth to the lesser of your earned income or $5,000 per spouse ($6,000 if you’re over 50)[1]. Second, once you start a Roth, you must wait until the longer of 5 years or age 59 ½ to take the money out tax-free[2]. Third, there are earning limitations to contributing to a Roth. For single filers, the limit is $101,000 of Modified Adjusted Gross Income (with a partial contribution for income between $101,000 and $116,000), and for married filers filing a joint return[3], the limit is $159,000 (and partial contribution for income between $159,000 to $169,000)[4].

A loophole around the income limit: There is an interesting strategy you can use to get around the income limitations for a Roth. We normally consider two types of IRAs, Roth’s and conventional. There is a third type, which is mostly ignored (for good reason), a nondeductible IRA. Nondeductible IRAs do not have an income limitation (you do need to have earned income to make a contribution). The income earned by a nondeductible IRA is taxable upon withdrawal. The loophole is that in 2010, you can convert non-Roth IRAs (like nondeductible and conventional or rollover IRAs) into Roth’s by paying the tax. So, you could have high income and make an on-sale contribution to a nondeductible IRA for yourself (and potentially your spouse) now for 2008; make another one in the beginning of 2009, and make a third in the beginning of 2010, and then convert in 2010 and pay the tax on the income portion and have yourself a Roth IRA. If you do the conversion in 2010, you’ll pay the tax half in 2011 and half in 2012. There are more rules, so check with your advisor before proceeding.

Overall, Roth IRAs are good wealth accumulation tools. They’re even more attractive in a market sale.

Roth conversions. What could be better than sticking five grand or ten grand in tax free at a market low? How about sticking a lot more in. Here’s where we look at a Roth conversion. A Roth conversion is where you take an existing IRA, whether nondeductible, traditional, or rollover, and convert it into a Roth by paying the tax on the earned income of the IRA. In a market decline, converting to a Roth can be very attractive. Say you have an existing traditional IRA that was $40,000 in October of 2007, and is now worth $25,000. If you convert to a Roth, and are in the 25% bracket, you’ll pay $6,250 in taxes to make the conversion. If your investments revert to their original value of $40,000, the entire IRA will be tax-free. You need to be aware that Roth conversions are neutral if you use the money in the IRA to pay the taxes. But if you can fund the tax on the conversion out of other after-tax funds, you clearly gain if you’re in the same bracket in the year of conversion or the years of withdrawals. Even with the 2010 conversion window opening (see above), we think that a low market allows for a conversion at lower prices and hence lesser taxes. Have a good look at your tax bracket: it doesn’t make sense usually to convert to a Roth if it takes you into a higher bracket.

The Catch: Like Roth contributions, there is an income limitation for Roth conversions as well. The Modified Adjusted Gross Income limit for all taxpayers not married filing separately (i.e. single or married filing joint returns) is $100,000.

Taking care of the kiddos, tax-free. Obviously, if we like making on-sale retirement deposits or conversions tax-free, we also like making on-sale education funding deposits tax free as well. §529 plans (Like the MESP[5]) and Coverdell ESAs are tax-free education savings vehicles. Making a deposit to a §529 in a down market gives more potential appreciation on a tax-free basis. Most education savings vehicles have age-based allocation for a child or grandchild. These age-based programs allocate toward cash as the student approaches college age. They also usually have conservative, moderate or aggressive allocations as well. Many parents and grandparents have established, prior to the rules of §529 or Coverdell ESAs, a Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) custodial arrangement. The UGMA or UTMA is only partially tax-free. In fact, they can be taxable at the parent’s rate. In a down market, getting rid of the UGMA/UTMA and depositing the money into a §529 or Coverdell would take a portion of the taxable gain away from the UTMA/UGMA and make it a tax-free gain in the §529 or Coverdell. There is an extra advantage to getting rid of UTMA/UGMAs as well: §529 and Coverdell ESAs are not counted as a child’s asset for financial aid purposes. This provides a prospective change in financial aid eligibility of about 29% of the balance of the account[6].

The Catch: Coverdell ESAs may be used for K-12 or college; §529 plans may only be used for college or higher education. Coverdell ESAs have a $2,000 per year per student limit; §529 plans generally have much higher limits. Coverdell’s have an income limitation for contribution of $110,000 of Modified Adjusted Gross Income for single filers ($220,000 for married filing joint returns)

Wealth Transfers on sale. Here’s one for folks with some significant assets. The decline in real estate and stock values provide an opportunity to make a gift to heirs (or better, a trust). Right now[7] taxpayers can make a $1,000,000 gift and use a portion of their Unified Gift and Estate Tax credit.[8] If someone had a significant portfolio or some appreciated property (business, ranch, real estate) that had suffered a market decline, this may be an optimum time to make a gift. The reason is that on larger estates (right now $2M for married couples, $3.5M in 2009 and after the year 2010 there is a very likely possibility of a change in that number for estate taxes), the use of a gift in a down market can potentially save all of the estate taxes on any future appreciation on the property.

First, the fear of a gift to errant or frivolous heirs is unwarranted. A gift can be made to an LLC or to an irrevocable Trust. There are some specific advantages when gifting through an LLC where the beneficiaries get a minority interest. It may be possible to gift significantly more than the $1 million dollar gift limitation using an LLC. Trusts and LLCs can restrict the use and transferability of assets to outsiders.

The basic idea is simple. Suppose Mike and Sue have a piece of property that was worth $6 million in 2005, but is now worth $3.5 million, as attested by the average of three appraisals. They want to keep the property in the family. They create MS Partners LLC, contribute the property to the LLC, and gift an LLC share equal to about 40% of the value to their various heirs[9]. Suppose they collectively live an additional 20 years, and the property appreciates to about $9 million[10]. On their death, the taxes saved by the gift would be about $1.8 million[11]. Use stocks or a closely held business, and the savings are more dramatic. The LLC can have Mike and Sue as the managing members and they can run the show.

The Catch: There’s a whole bunch of catches. You need to set up an effective gift vehicle (like an LLC or irrevocable trust), you need effective valuations, and you have tax returns to file for the reception vehicles. There are income tax consequences to consider as well (there are weird rules about the basis of property transferred by gift: usually we want something appreciated and not at a loss.) In addition the valuation procedures are critical. But in many cases, the rewards to the family can be substantial. Overall, it’s a complex transaction with substantial benefits.

Wash the losses right out of your head. In a down market, it makes some sense to harvest losses (‘harvest’ being the euphemism for simply ‘take the losses’) in your taxable (non IRA or 401(k)) accounts. However, losses are strange: you can only net losses against gains and then take a portion (currently $3,000 a year) against ordinary income. However, since you can carry-over losses indefinitely, it makes sense to realize losses. In a weird and volatile market, you could miss a 1,000 point run by being out of the position. The Internal Revenue code requires that you cannot take a loss on a security if you hold substantially the same position within 30 days of the sale. So if you had a loss on the sale of shares of a stock you had owned, you couldn’t deduct the loss if you owned the same stock for 30 days prior to or after the sale. This problem, called a ‘wash sale’, can be overcome simply in some cases, and less simply in others.

The wash sale rule disallows losses on substantially identical securities if a purchase is made within the 61 day period centered on the sale. So If you had XYZ stock that was $2, which you had bought at $8, that you sold on March 15, 2008, you couldn’t claim a loss if you bought XYZ anytime on or after February 14th (30 days before) or before April 15th (30 days after). You can’t get around this easily either. For example, you can’t buy an option on the company in the wash period to deduct the loss. You also can’t apparently make a wash in an IRA you own[12] (sell at a loss in your taxable account and buy in the IRA). You can however, possibly switch among similar mutual funds (for example, the jury is out on what happens if you swap an S&P 500 index fund for a SPDR, but you could clearly switch an index for a bounded index or a social index). You can also follow the ‘rising tide’ theory, in which you might have a loss on Citigroup, and sell it and hold JP Morgan for 31 days to get the loss.

There you have it: five ideas to take advantage of a sale in the market. Stay tuned for our next installment on bear market ideas.

Leon LaBrecque

[1] For 2008.
[2] There is an early withdrawal rule called FIFO (first-in, first-out) that allows earlier withdrawals of contributions only.
[3] For some unforeseen reason, the income limit for married filing separately is $0, and a partial phase-out to $10,000 of MAGI.
[4] For 2008.
[5] For Michigan residents (the custodian, not necessarily the child), there is available a deduction from Michigan taxable income of up to $10,000 for contributions to the Michigan Education Savings Program (MESP). Note that the student can go to any school under the MESP, not just Michigan Schools.
[6] For financial aid calculations, 35% of a child’s assets (including UTMA/UGMA) are counted toward the cost contribution. Only 5.6% of the parent’s assets (§529 plans or Coverdell) are counted.
[7] 2008.
[8] If the tax payer dies within 3 years of the gift, and the gift is considered “incomplete”, it will be added back to an individual’s estate for estate tax purposes. You should consult with your advisor or legal counsel to ensure you are making a completed gift.
[9] We’re using a relatively standard discount on a non-transferable, minority interest in a closely held business.
[10] About 5% appreciation, not grossly unreasonable.
[11] Assuming a 50% estate tax on estates larger than $3.5 million per estate, which is close to proposed changes in 2008.
[12] Rev. Rul. 2008-05