By Kyle Hafstad, Estate Planning Advisor
Investors are feeling the burn of a bear market this year. A confluence of macroeconomic factors, including the lingering effects of COVID-19, the war in Ukraine, supply chain constraints and rising interest rates, has taken markets lower.1
As investors, we know bear and bull markets ebb and flow. However, with inflation hovering above 8%,2 many investors can get discouraged and distracted from their long-term goals and react more pessimistically than usual. As a result, estate planning may not be top of mind for some investors, but it should be; there is a real opportunity to utilize gifting in a way that can make a larger impact than normal. Below, we examine how investors can leverage current market conditions to benefit their estate plans.
Gifting is the bread and butter of estate planning. People apply gifting strategies to their estate plans to provide for family and friends now, and in the future, while minimizing taxes applied to their estate.
The most commonly used strategies capitalize on annual gift exclusions and lifetime gift exemptions. Right now, the annual gift exclusion allows you to give up to $16,000 per year per beneficiary, or $32,000 for couples.3 For example, a grandparent can make a present interest gift to their grandchildren of $16,000 each, completely tax-free. In the current bear market, it might be tempting to gift cash rather than securities because many assets have fallen in value. However, when the market inevitably recovers, any gifted securities will appreciate and be more valuable than cash in the long run. Meaning when those grandchildren want to tap into their gifts in two or three years, the initial $16,000 will have likely increased significantly.
Lifetime gift exemptions, or unified credit, provide much larger gifting opportunities and can be used either during life or at death. The cap on these gifts is $12.06 million per individual or $24.12 million per couple.3 We can apply the same thinking to this strategy: gifting assets that are depressed in value can create more appreciation that happens outside of the taxable estate, benefiting the beneficiaries.
While making these gifts outright to children, grandchildren and other family and friends is an adequate strategy, it may be prudent and more advantageous to examine other strategies.
People often use more structured gifts, like trusts, to provide assets for more than one generation. One commonly used strategy is a grantor retained annuity trust (GRAT), also called a split-interest gift trust, in which the grantor retains the right to an income annuity on the assets they gifted into a trust.4 After a certain term of years, the remainder of the trust passes on to the beneficiary.
Another trust used to maximize gifts is an irrevocable defective grantor trust (IDGT). With this strategy, there is no annuity income retained by the grantor. Instead, the entire principal of the gifts made into trust, and all resulting appreciation, is transferred outside of the taxable estate, purely in favor of the beneficiaries.5
In our current market environment of depressed asset values and relatively low federal interest rates, selling the assets to an IDGT, in addition to gifting, through an installment sale can further leverage the trust planning. To do so, we must use an IRS-published interest rate (i.e. Applicable Federal Rate) for intrafamily loans, which currently lingers at 3.43% for a long-term note.6 We’ve seen historically low IRS interest rates for the last 10 years and, while rates have certainly gone up, it is still a very favorable rate overall.
As such, we can use the low-interest rate combined with depressed asset values to exponentially increase our leverage on what we can move outside of the estate, without any gift or estate tax consequences. The sale strategy essentially mirrors an arbitrage strategy – if we gift assets while they are depressed, they will likely earn more than the typical 7% over the shorter and longer term once they recover. The sooner we transfer assets at a lower value, the longer runway we have for future growth and appreciation of those assets outside of the estate.
While gifting and trusts can be beneficial in a bear market, it is important to underline certain drawbacks. Once a gift is made in any of these scenarios, there is no step-up in basis on those assets once the person who made the gift passes away, which increases future capital gains tax liability for the heir when they finally dispose of the asset. However, the estate tax rate is roughly twice as high as the capital gains rates (40% vs 20%). We’re effectively cutting the tax rate on a transferred asset that has appreciated in half, for those with estates that are in excess of the current unified credit limits. For smaller estates, it may make sense to hold onto an appreciated asset until death for a step-up in basis.
Another strategy most people are familiar with are 529 plans, which are designed to save for children’s and grandchildren’s future education costs. While these plans apply to a broader range of investors, the same down-market benefits used for gifts and trusts can be practiced here. Investing into a 529 plan today, while the market dips, may allow assets to further appreciate over time and, once pulled out, earnings are completely tax-free if used for qualified education purposes.
There is no denying that market downturns can cause short-term pain for investors. However, it is crucial to remain diligent and aware of the strategies that, if implemented now, could propel your investments and planning further once we start to recover. If you have any questions about estate planning amid current conditions, feel free to reach out to Kyle Hafstad at firstname.lastname@example.org.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971.