US Expat resources

Investment planning in times of financial stress

By Jonathan Gold | 30 Jun, 2020

The COVID-19 crisis of 2020 has taken its toll on the world – the tragic loss of life, the devastating social distancing from loved ones and the financial impact on economies across the globe.

Global equity markets fell sharply from the middle of February, with drawdown levels of -35% in just 4 ½ weeks. Volatility reached record levels, higher even than the Global Financial Crisis of 2008. Safe-haven assets including bonds and gold were not immune to the selloffs.

The response from Central Banks was swift, decisive and coordinated, with interest rate cuts to near zero, stimulus packages greater than the Marshall Plan post WW2 running to trillions of dollars and promises to do ‘whatever it takes’ to support employees and employers.

Markets have recovered some of their losses but remain volatile.

The factors that have led to this crisis differ from any other in living memory. However, as with other previous crises, times of financial stress create opportunities for investment planning and organizing one’s financial assets.

Cleansing tax-inefficient investments

The old adage states “don’t let the tax tail wag the investment dog”. But for many, the prospect of realising a large gain that could have a significant known cost in terms of the tax consequences prevents them taking action.

This is magnified where the assets have been invested in holdings that are subject to income tax rather than capital gains taxes, meaning tax rates of up to 45% rather than 20%. Often these involve foreign mutual funds, known in the UK as Offshore Income Gains or OIGs. For US citizens, non-US funds are referred to as Passive Foreign Investment Companies or PFICs. Both are taxed as income rather than capital gains.

For investors who had been holding off liquidating big gains held in PFICs or OIGs because they would be taxed at 45% in the UK or up to 37% in the US (plus additional state and Net Investment Income Tax), with the fall in asset values, now may be the time to do so. Selling at a lower value means less (or no) tax and the opportunity to rebuy into more tax efficient directly held assets.

Lifetime Gifts

Gifts are treated as disposals for tax purposes. Investors with large gains in their portfolios may have been reluctant to make gifts to the next generation for the tax consequences. The reduction in asset values may represent a timely opportunity to revisit estate planning. Assets can be sold or transferred in-specie to the beneficiary. This is particularly effective for growth assets with significant growth potential, where the future appreciation can occur outside of the donor’s estate

Realizing capital losses

Assets sold at a loss can be used to offset equivalent gains. If assets have fallen significantly so that they are sitting at a loss, this may be used to offset gains made from sales of other assets. These losses can be carried forward indefinitely to match against future gains.

Investors may question the notion of selling when prices fall and being out of the market. After all, it should be ‘buy low, sell high’ and not the other way around. This would be the case if the assets were simply sold. But it would not necessarily apply if the proceeds are subsequently reinvested into an equivalent strategy or new investment plan.

When doing so, one needs to be careful to avoid the wash sale/bed and breakfasting rules by rebuying the same assets within 30 days. HMRC and the IRS can potentially disallow losses if done too quickly.

One further note of caution. Investors also need to be aware of currency movements and not just the rise or fall in asset values. HMRC in the UK only thinks in GBP, whereas the IRS only thinks of the change in value based in USD. So, whilst stock prices may have fallen, currency movements may create a taxable gain.

This may be a good time to realign the portfolio by harvesting losses in part or all of a portfolio. However, each case needs to be considered individually.

Reconsidering risk and the investment strategy

At the latter stages of an investment cycle, it is not unusual for investors to find that their investment managers have increased their exposure to equities. In the run up to the recent correction, an average balanced portfolio had an equity weighting of 55% (Source: Enhance MPI Med Risk GBP Q4-2019). Whilst a manager with an active investment style may have outperformed the market, those investors who had chosen a passive strategy using tracker funds or ETFs will have felt the full impact of the drawdown.

For those managers that were more cautious and held less equities, the impact of the drawdown would have been softened. And in those cases where a manager had chosen more defensive stocks, then the investor may have been further protected.

Investors may find that the recent market correction has given them an insight into their true risk tolerance. They may also have found that their investment managers had not positioned their portfolios the way the investor had thought they were.

London & Capital provide financial planning and tax-efficient investment management strategies for Private Clients, including a team specialising in US-connected clients.