Estate Planning Strategies During Volatile Markets

Four specific strategies that clients can use to take advantage of market uncertainty and reduced asset values to better achieve their tax and estate planning goals.

Volatility is certainly a defining characteristic of our current market environment. Recent turmoil in the banking industry, uncertainty related to inflation and interest rates, and continued geopolitical unrest have all shaped the market environment of today. As a result, many investors have experienced a reduction in portfolio values, and are unclear on the most appropriate response.

Fortunately, even in depressed and volatile market environments, there are strategies that can be implemented. Some strategies are simply to reduce risk, while others can take advantage of reduced investment values.

Here, we will address four specific strategies that clients can use to take advantage of market uncertainty and reduced asset values to better achieve their tax and estate planning goals.

1. Roth Conversions

Converting a Traditional IRA or other qualified retirement assets to a Roth qualified retirement account can help minimizing taxes during one’s lifetime, while increasing the value of assets left to heirs. A Roth conversion can also offer several advantages in a volatile market, particularly when asset values are temporarily depressed.

The key benefits of Roth accounts include: no required minimum distributions (RMDs), tax free income to heirs (though inherited assets may be subject to the 10 year rule), tax-exempt growth and withdrawals, and tax diversification.

Although Roth IRAs are unique in their ability to provide tax free growth, the ability to make contributions to Roth IRAs is phased out for many high-income earners. A Roth conversion offers a way around the income limitations in order to take advantage of the many benefits of this type of retirement asset.

A key consideration in making a Roth Conversion is the potential tax liability. As traditional qualified retirement accounts generally have no income tax basis, when qualified assets are converted to a Roth, the full amount converted is taxed as ordinary income. Volatile markets provide declines in asset values making for an opportune time to mitigate the potential tax liability associated with the Roth conversion. Ordinary income taxes would apply to the account’s depressed value and any future appreciation of the new Roth assets, along with any future distributions, are tax free.

While there can be numerous benefits from converting traditional qualified retirement accounts to a Roth, a quantitative analysis should be conducted to ensure those benefits are not overcome by other factors. These factors include the taxpayer’s current and future income tax brackets, the taxpayer’s ability to use nonretirement assets to pay the additional tax liability assessed upon conversion, and the amount of time the assets will remain in the Roth account before needing to be accessed.

2. Exercise of Stock Options

For taxpayers who receive stock options from their employer, volatile market conditions may be a time to consider the exercise of their options. With traditional Non-qualified Stock Options (NSOs), granted shares are offered at a set price, known as the ‘strike price’ or ‘exercise price.’ The benefit to the employee is that they have the option to purchase, or ‘exercise,’ shares at this price which may be lower than the current fair market price. However, when the shares are exercised, ordinary income taxes are due on the difference between the fair market price and the strike price. The benefit of exercising during a period of market decline includes a potential reduction of income tax liability and additional ownership in the stock for which options were exercised.

For example, if XYZ, inc. grants 1,000 shares at $5, and the employee decides to exercise these shares when the stock is valued at $10, ordinary income will be due on $5,000 ($10,000 FMV-$5,000 Exercise Price).

For employees of companies that have strong fundamentals and are poised for long-term growth, a temporary market decline may offer a good opportunity to engage in an analysis of their current stock options to determine if exercise is prudent.

3. Outright Gift

For those who would like to gift assets to family or other beneficiaries during their lifetime, the implementation of an outright gift may be an effective strategy during a market downturn. Gifts may be in the form of business interest, stock, mutual funds, real estate, or other assets that may be subject to value fluctuation. When a gifting strategy is executed based upon a reduced value, the amount of lifetime gift tax exemption used will also be reduced. Moreover, future growth of the gifted assets may be removed from one’s estate for a lower cost.

The 2023 lifetime exemption amount is $12.92MM per individual, or $25.84MM for a married couple. Once the lifetime exemption is exhausted, any gifts made are subject to a tax rate of 40%. In addition to the lifetime exemption, each person is allotted an annual gift tax exclusion of $17,000 (2023) per donor to each individual for whom a gift is made. A married couple can therefore make gifts of $34,000 per recipient in a given year without having to file a gift tax return. For gifts that exceed this exclusion amount, the taxpayer must file a gift tax return (Form 709) even if gift tax is not due.

Individuals interested in making a significant gift, should engage in a gifting analysis as part of their wealth plan. This analysis can measure the potential impact the gift will have based upon the depressed value provided and potential appreciation beneficiaries may receive.

4. Substitution Powers for Grantor Trusts

Leveraging the substitution powers of Grantor Trusts is another way to take advantage of current market uncertainty. A Grantor Trust is designed to reduce estate taxes and benefit heirs. Grantor trusts generally include Grantor Retained Annuity and Unitrusts, Spousal Lifetime Access Trusts (SLATs), Defective Grantor Trusts, and any irrevocable trust that leverages the grantor trust rules pursuant to IRC Sections 671-678. The assets used to fund the trust are considered a gift for gift tax purposes, but the gift value may be reduced based upon the characterization of the asset funding the trust and the type of grantor trust chosen.

It is important to note that the Grantor is responsible for paying income tax generated by assets within the trust. Payment of income taxes by the Grantor does not result in any additional taxable gift. In turn trust assets may have the potential for significant gain over the life of the trust as they are unencumbered by the tax burden. In return for shouldering the tax liability, the grantor may be provided certain powers related to assets held within the trust. One such power is the “power of substitution.” If executed correctly, the “power of substitution” will allow the Grantor to potentially swap assets outside of the trust with assets inside the trust of equal fair market value.

This power is particularly useful if the asset values within the Grantor Trust have significantly increased during times of market fluctuation. Use of the substitution power may provide flexibility for the Grantor and the trust’s beneficiaries in determining if there are strategic opportunities to enhance trust holdings and future tax efficiency. Examples of a “substitution of assets” between the Grantor and grantor trust include the “swap” of cash, securities, or real estate for equal value. The IRS has recently held that assets gifted to a grantor trust maintain a carryover basis from the Grantor. It is important to discuss with your legal and tax advisor proper formalities to ensure the correct implementation of this strategy.

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