Planning techniques in a volatile market
First some background: current gift and estate tax landscape
In 2021, each individual is able to transfer up to $11.70 million during one’s lifetime or at death without a federal gift or estate tax. A married couple could transfer up to $23.4 million. Transfers above the exemption may be taxed at a rate up to 40%. As currently legislated, the exemption will drop to roughly half of the current amount in 2026 (approximately $6 million to $6.5 million per individual after adjusting for inflation). In order to take advantage of the current higher exemption amounts, market volatility, and low interest rate environment, you can consider several timely estate planning strategies.
Strategies to take advantage of tax benefits
There are several methods you can use to optimize your family’s tax picture and transfer wealth to family members; below, we highlight the most common. We have separated these into income tax techniques and transfer tax techniques. Both are important to consider. These techniques are even more impactful when asset values are depressed and interest rates are low. We present them in order from simpler to more complex.
Income tax strategy—taking advantage of lower asset values
If you were considering converting your traditional IRA to a Roth IRA, an optimal time for such conversion may be when asset values in the IRA have declined. Although you will owe income taxes at the time of conversion, the taxes may be reduced if the conversion takes place during a market decline. Roth IRAS do not have a required minimum distribution (RMD) for the account owner, and although most non-spouse beneficiaries must still withdraw the Roth IRA sums within ten years of inheriting them (or more quickly), all withdrawals by beneficiaries (including of appreciation on Roth IRA assets) are income tax free. Compare that with a traditional IRA, where RMDs for the owner must begin at age 72, and withdrawals from the inherited IRA by beneficiaries are income taxable to them. Given current individual income tax rates, a decline in the markets, and an expected reversion to higher income tax rates in 2026 if not sooner, this may be an opportune time to review whether a conversion makes sense for you.
You should ensure that you have the funds in a taxable account to pay the tax liability on conversion; if you don’t have enough assets outside the IRA to pay the taxes associated with conversion, a conversion becomes far less beneficial.
Note that you can no longer “re-characterize” or undo a Roth conversion. This means that if after the conversion you want to undo it (for example, if asset values decline but you’ve already paid income tax on the higher value at conversion), you cannot. Be sure to consult with your legal and tax advisor to determine if a conversion makes sense for you and if it may negatively affect you in other ways.
Transfer tax strategies—taking advantage of lower asset values and low interest rates
Outright Gifts: The simplest thing you can do to take advantage of lower asset values for transfer tax purposes is to make outright gifts. Giving undervalued assets (such as stocks, bonds, mutual funds, ETFs, business interests, etc.) reduces the value of the assets that are ultimately included in your estate and potentially subject to estate tax and transfers all of the growth of those assets to your children or other beneficiaries. If you are able and willing to transfer assets to your beneficiaries, a market decline presents an excellent opportunity to use less of the transfer tax exemption to transfer wealth and appreciation out of your name. You should work with your tax advisors when selecting assets to gift to avoid any negative tax consequences (e.g., gifting assets with embedded losses, which could jeopardize the loss).
Intra-family loans: a relatively simple way for you to plan around low interest rates is to make a cash loan to the person whom you wish to benefit. If the assets purchased with the loan appreciate more than the interest rate on the note, the spread between the return and the interest rate will accrue to the borrower on a gift-tax-free basis; obviously, this technique can also take advantage of lower asset values.
In addition, when interest rates have dropped, you may wish to consider refinancing existing intra-family (and other) loans. By refinancing while rates are lower, more of the appreciation stays with the borrower versus being returned to the lender in the form of interest.
For further discussion, please read our publication: WealthFocus: Estate planning in a low interest rate environment.
Transfers to Grantor Retained Annuity Trusts: A GRAT is an irrevocable trust. The grantor of the trust contributes an asset the grantor believes will appreciate during the term of the GRAT. The grantor’s original contribution plus an interest rate set by the IRS in the month of the original contribution is returned to the grantor over a term (most frequently two or three years). Because the grantor receives back from the trust what the grantor put in (plus some interest), there is no gift tax on the initial transfer—this is known as a “zeroed-out GRAT.” At the end of the GRAT term, the appreciation above the grantor’s contribution and the IRS interest rate passes to the named beneficiaries (or a trust for their benefit) without a gift tax consequence. For income tax purposes, the trust is disregarded during the term of the GRAT and the trust income and gains are taxed to the grantor. This provides for an additional method of transferring a tax-free gift to the beneficiaries in that the trust can continue to appreciate without being depleted by the tax liability on its growth or its gains. You could transfer significant wealth without a gift tax assuming the asset value increases during the GRAT term.
Example of the inflows/outflows of a GRAT
Installment Sale to a Defective Grantor Trust (IDGT): An installment sale to an IDGT functions like an intra-family interest-only loan except (i) the borrower is a trust, structured as a grantor trust for income tax purposes and the lender is the donor of the trust, and (ii) the sale is usually of non-cash assets. Any asset appreciation over the applicable interest rate will accrue to the trust rather than the donor. This transaction is more complex than an intra-family loan in that the lender needs to create a trust and fund it with seed capital to ensure that the trust is a creditworthy borrower. However, the estate planning benefits of this transaction can be greater than those of an intra-family loan since the assets in the trust grow on an income-tax-free basis as the tax liability is the responsibility of the grantor (similar to a GRAT during the GRAT term). During times where both the asset values and interest rates are low, IDGTs may help successfully transfer significant appreciation to trust beneficiaries.
For further discussion, see our publication: WealthFocus: Estate planning in a low interest rate environment.
Exercise substitution powers in existing GRATs: One of the primary goals of a GRAT is to shift appreciation to heirs; but what happens when a transferred asset declines in value? Enter the substitution or “swap” powers that are contained in many grantor trusts, including most GRATs. Those powers permit the grantor of the trust to swap assets of equivalent value with the assets in the trust. Assuming these powers exist in the trust, during times of market volatility where asset values may have dropped since inception of the trust, the grantor may be able to swap personal assets such as cash in return for the asset in the trust and then either (i) transfer the asset to a new GRAT or (ii) do an installment sale with the asset to a new or existing IDGT. By doing so, the grantor may be able to still transfer appreciation from that point onwards to his or her heirs, taking advantage of both lower asset values and lower interest rates.
For example, assume Jane set up a two-year zeroed-out GRAT at the beginning of this year, and funded it with ABC stock with a fair market value of $1 million at the time of transfer. Assume a couple months later, the market value of ABC stock drops to $800,000, and also assume that a year later the stock goes back up to the original $1 million. If Jane did nothing, the result would be that she would receive the full $1 million back during the term of the trust, and her heirs would receive nothing as there was no appreciation beyond the initial transfer. However, if Jane had used her swap powers when the value of the stock dropped to $800,000, she could have transferred cash from her personal account to the GRAT in exchange for ABC stock and then transferred the ABC stock to GRAT #2. When ABC went back up to $1,000,000, Jane would get back her $800,000 (plus interest) and her heirs would receive the remainder of slightly less than $200,000 without a gift tax.
When substituting assets, you should work closely with your estate planning attorney and tax advisor to ensure that the transaction is clearly documented and the necessary paperwork is prepared. Among other things, it may make sense in certain circumstances to file a gift tax return, and if assets that are being swapped in or out are not publicly traded, you may need an appraisal to evidence their fair market value.
Times of market volatility can be challenging; however, that same volatility creates opportunities to engage in tax-efficient planning that can help you achieve your long-term goals. Not every strategy is a good option for every individual, and it is important that you seek the advice of your legal and tax counsel to determine the best course of action for you based on your individual goals and objectives.
For more information and additional considerations relating to any of these strategies, contact your J.P. Morgan Advisor.