As I write this article, I’m working remotely at home. My puppy is tugging at my feet for my attention and my six-year-old son is sitting next to me hard at work powering through his school assignments on his iPad. Earlier this morning he attended his first virtual class with 20 or so of his classmates (kindergarteners) interacting through a webcam and a computer monitor. As you can imagine, it was joyful chaos. But behind the smiles and laughs, it was all quite surreal and a little unsettling.
Every crisis is different. Or at least the cause of every crisis is different. However, this time it really feels like we are in uncharted territory. And to some degree, that’s true. The crisis is resulting in millions of workers losing their jobs at an unprecedented rate, uprooting daily routines, forcing many to work remotely, causing parents to homeschool their kids, changing the way we interact with friends and family and making many wonder what life will be like after? What’s the new normal? Yet, there are similarities that reverberate. The pattern of increased uncertainty, leading to feelings of fear for some and opportunity for others is all too familiar. In times like these, we see an expansion of the range of rational beliefs that cannot be logically disproved.
So what can you do? Well, the purpose of this communication is to share several ideas that can provide opportunities during times like these, where asset values are depressed and interest rates are low.
Of course, we had to start here. Having a financial plan is the guiding map that allows us to identify where you are currently, where you’re headed and how much flexibility you have to navigate uncharted territory as you work towards the future you envision. For some, there are limited options. For others, there are opportunities to better manage wealth, optimize taxes, and enhance gifts to loved ones.
Monte Carlo Analysis:
In layman’s terms, a stress test. This statistical analysis allows us to plan for, measure and manage risk to your financial plan caused by expected, but unforeseen disruptive market events. Some clients want to plan for worst-case scenarios. For others, living a more fulfilling lifestyle and sharing wealth is worth taking some risk, with the understanding that if a steep and prolonged crisis does occur, then adjustments will need to be made. Your investment strategy and spending goals significantly impact the risk to your financial plan.
In a crisis, the saying goes “cash is king.” You want to have a plan for meeting your cash flow needs during a crisis. Start with your total spending goal and then subtract sources of income such as Social Security income, pension income, rental income, annuity income, etc. If your sources of income do not cover your spending goals, then you need to fund the gap with your investment portfolio. Consider having 1-2 years of portfolio withdrawal needs in cash equivalents (such as a money market fund), then another 3-5 years of withdrawal needs to be invested in low-risk bonds, such as Treasuries, securitized bonds and high-quality corporate bonds. This will ensure you have cash to weather an economic downturn and prevent you from needing to sell riskier assets at depressed values. When you have your bases covered, you can consider more advanced techniques.
There are several factors to consider in determining if Roth conversions are the right strategy for you. We wrote about this extensively in a prior blog. Generally, a Roth conversion strategy entails executing a series of conversions over a number of years to smooth out taxes. Once you determine the optimal dollar amount to convert each year, the best time to convert during the year is during a down market. This allows you to convert assets at depressed values (which is the amount you pay income tax on) and all subsequent appreciation is tax-free in the Roth IRA.
For example, assume you have a $1,000,000 traditional IRA. If you were to convert it at that value, you would pay taxes on $1,000,000 of income. However, assume there is a severe market downturn and now your IRA is worth $700,000. If you convert at that time, then you would pay tax on $700,000 of income. And of course, the assumption is that markets recover, and therefore, all of the recovery and future appreciation is tax-free.
In practice, it’s rare to convert all of your IRA assets in one year. As mentioned earlier, the strategy entails executing a series of conversions over a number of years. And generally, you convert shares in-kind as opposed to cash. For example, assume your analysis determines that the optimal amount to convert each year for the next 10 years, is $100,000. And assume you own 10,000 shares of an investment that is valued at $100/share. At the current price per share, you would convert 1,000 shares (1,000 shares x $100/share = $100,000). However, if there was a decline in the market and the share price is $70/share, then you would convert 1,429 shares (1,429 shares x $70/share = $100,000). So, in this example, the downmarket provided the opportunity to convert an additional 429 shares with the same tax liability.
When you transfer property during your life to someone else for less than full and adequate consideration, gift tax may apply. The amount of the taxable gift is generally based on the fair market value of the property you transfer. There are lots of rules to be aware of and sophisticated planning techniques to reduce the value of the gift in some way (we will save a discussion of those for another blog), but suffice it to say, in this environment, the market is providing a discount.
Similar to the concept for Roth conversions, you can gift assets at depressed values. The idea is that you will pay less tax, or utilize less of your lifetime exemption when you make a gift and that all future appreciation will be removed from your estate. And, so long as your gift is a complete, present interest gift, you can gift up to $15,000 per year, per recipient that qualifies for the annual exclusion. So, if you were thinking about making a gift this year, consider making it now as opposed to making it at the end of the year.
Spousal Lifetime Access Trust (SLAT):
With a SLAT, one spouse creates a trust for the benefit of the other spouse, and vice-versa. The goal of this structure is to remove property from your estate while still having access to the funds. The way it works is one spouse transfers property into the trust and utilizes their lifetime exemption removing the property and future appreciation from their estate. The other spouse is a beneficiary of the trust and can access the assets with some limitations. And, with the lifetime exemption of roughly $11.5 million set to decrease significantly in 2026, this is also a good planning opportunity to utilize the exemption now. SLATs do have some unique rules you need to navigate, like the reciprocal trust doctrine, so working with an experienced attorney is really important.
Grantor Retained Annuity Trusts (GRAT):
A GRAT is a wealth transfer technique that, if structured a certain way, referred to as a zeroed-out GRAT, allows you to transfer wealth without incurring gift tax and without utilizing your lifetime exemption. The way it works is that the person gifting property, referred to as the grantor, transfers assets expected to appreciate into a trust and then retains an annuity payment for the duration of the trust. At the end of the trust term, the remaining amount is transferred to the remainder beneficiaries.
The requirement for a zeroed-out GRAT is that the present value of the retained annuity interest must equal the fair market value of the property transferred to the trust. Any appreciation over that amount is transferred to the remainder beneficiary. That seems complicated, but with the right software, it’s a pretty straightforward calculation. The key here is the Section 7520 rate. It’s essentially an interest rate determined on a monthly basis and used to value gifts. With a zeroed-out GRAT, the appreciation in excess of the Section 7520 rate goes to the remainder beneficiaries. So, the lower the rate, the more appreciation the remainder beneficiary receives and the more effective the wealth transfer technique. With rates being so low, now could be a good time. The Section 7520 rate is now 1.2%. A year ago, it was 3.0%
Here is an example assuming $1,000,000 of assets are transferred into a 5-year, zeroed-out GRAT appreciating at 10%, with a Section 7520 rate of 1.2%:
In this example, the grantor retains annual annuity payments of $207,258.10 for five years. After the term, the remaining amount of assets, projected to be $345,178.58, is transferred to the remainder beneficiary.
For comparison, if we make the same assumptions, but used the Section 7520 rate a year ago of 3%:
Of course, no one can guarantee the asset will appreciate at 10%. That number was used purely for illustration purposes. Ideally, the underlying assets appreciate, but that is not always the case. In the event they don’t, the grantor continues to receive as much of the annuity payments that the assets will provide, and if there is nothing remaining in the trust, then there is nothing to transfer to the remainder beneficiaries. A way to help mitigate the risk of a non-performing GRAT is to establish more than one. You can establish multiple GRATs with shorter terms over multiple years, referred to as rolling GRATs, and you could also fund them with different investments.
Charitable Remainder Unitrust (CRUT):
I know, I know, for those of you that love this stuff like I do, you might say to yourself that now is not the best time. And, having an understanding of how the math works, I agree, depressed values and a low Section 7520 rate are not mathematically optimized. But hear me out.
If you have a concentrated stock position that is well below its 52-week high price but still has a large capital gain, the only thing worse than the thought of selling now is the thought of selling now and then paying a lot of taxes. And of course, the problem with holding a concentrated stock position is the risk it presents to your financial plan and that it may not recover as quickly as a diversified equity strategy or provide the income you need. In this scenario, a CRUT might make a lot of sense.
With a CRUT, you establish and fund a trust and retain an interest during your lifetime, someone else’s lifetime, or for a term of years. At the end of the trust term, the remaining amount in the trust goes to a charity or donor-advised fund you name. A benefit of the CRUT is that it does not pay income taxes. So you can contribute highly appreciated assets and sell them in the trust, not pay taxes immediately and fully invest the proceeds into a diversified strategy. Upon the funding of the trust, you receive an income tax deduction for a charitable contribution, and during the life of trust, you receive a distribution that is a percentage of trust assets. It’s important to note that the distributions you receive are not tax free. The capital gains you didn’t have to pay immediately get spread out over the distributions you receive. So, in effect, you are deferring taxes.
To provide an example, assume you fund a CRUT with 1,000,000, the assets appreciate at a rate of 5%, you are 70 years old and establish the trust for your lifetime, and you want to “optimize” the calculation to that you maintain the maximum retained interest:
In this example, your percentage payout rate is roughly 25%. So, every year, you revalue the assets and take a distribution equal to roughly 25%. You’re also able to claim a charitable income tax deduction of about $100,000 in the first year.
As you can see, there are several planning opportunities to consider in the current environment. While this list isn’t exhaustive, we wanted to go into some depth about several of the more prominent ideas. Please let us know if you have any questions or would like to discuss further. We always strive to be a resource.
NumberCruncher is the source of all charts in this article.