With equity markets dropping this year, there is an unsettling feeling that the market may see a prolonged major “correction” or market decline. But for those individuals who can maintain a level head during market drops and take advantage of them, they may see the greatest benefit to their long term financial and estate planning goals. Today we are looking at some estate planning tips that could potentially allow you to capitalize on volatile market swings for your long-term estate planning needs.
You are generally only allowed to contribute cash to qualified retirement plan assets. However, the one exception is that you can transfer securities instead of cash between qualified retirement plan accounts. This means that if the market drops in value, it can be a perfect time to transfer securities from a traditional IRA to a Roth IRA in order to perform a Roth IRA Conversion.
To illustrate, let’s say John has a Traditional IRA with 10,000 shares of stock A worth $20,000 in February 2020 and this account drops in value to $14,000 in March 2020. If John decides to transfer the 10,000 shares from his Traditional IRA to his Roth IRA in March 2020 when the value is down, his taxable income generated from the event is $14,000 even though the value of the shares returned to its original $20,000 value inside the Roth IRA account by the following August 2020.
When performing a Roth Conversion, you are generating taxable income that will be taxed at ordinary income tax rates. It generally makes the most sense to pay the income taxes from outside cash or taxable accounts, so you can preserve the tax-deferred or tax-free nature of the qualified retirement accounts. You might also consider paying the income tax in the quarter when you perform the Roth Conversion to avoid any late penalties that may arise from required tax payments.
Another way to take advantage of a drop in the market is using your annual gift tax exemption amount, which is $16,000 per beneficiary for 2022. By gifting securities with a suppressed market value of around $16,000, you provide a tax-free gift to heirs and your heirs can continue to hold the investment until it rebounds. You will want to work with your advisor to be sure you select appropriate securities to gift. For example, you don’t want to gift assets with an embedded loss because you will lose the tax benefit of deducting that loss against ordinary income.
GRAT (Grantor Retained Annuity Trust)
With the prospect of a suppressed market values in the future, many clients are taking advantage of market volatility to set up and fund an irrevocable trust called a GRAT when the time is right. The donor of a GRAT places securities that have the potential to appreciate highly into the irrevocable trust. The trust then owes fixed interest payments back to the donor each year and the interest rates are set by the IRS’ applicable federal funds rates which are at all-time lows. At the end of the GRAT’s term (which has a two-year minimum), the original contribution to the trust is returned to the grantor. Because the grantor receives back the original contribution as well as interest payments, there is no gift tax on the transfer. Any appreciation of the securities over the original contribution and interest payments then passes to the beneficiary of the trust income tax and estate tax free.
To illustrate, if Sally set up a GRAT in March 2020 with $10 million of an index fund that tracks the S&P 500, the GRAT would be worth $16.6 million in March 2021 after accounting for any interest payments back to Sally. This means Sally could be on track to transfer $6.6 million outside of her estate to beneficiaries.
Important to note there are risks associated with any of the above actions – we’d be happy to discuss further.
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Disclaimer: Information provided is for educational purposes only. HBWM does not provide tax, legal, compliance, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. Further, HBWM makes no warranties with regard to such information, or a result obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.