Can Your Financial Plan Handle Volatility? – When financial markets hand you a lemon, it’s a chance to make lemonade in your estate plan. If stocks and bonds hit a turbulent patch, one philosophy says to patiently sit out the bumps and hang on until we reach the other side. While that may be a prudent approach for an individual investor’s own portfolio, other principles apply when it comes to updating your estate.
A volatile market provides the opportunity to mitigate tax exposure. The end goal is to leave your heirs the maximum sums of money permissible. You can accomplish that by adjusting the structures you are using. Tax laws are constantly evolving. Keep on top of the latest developments in order to ensure your assets reach the intended heirs in the optimal time and manner to exploit any tax-free transfers and pay at the lowest rates.
Gifts that go on giving
Consider gifts. When markets have fallen and asset prices are under pressure, you can give more stocks or bonds to make up your annual gift allowances. Another way to squeeze the lemonade is by making interest-bearing loans. If the beneficiary uses the loan money to buy depressed assets and those assets subsequently gain more than the interest rate you are charging on the loan, the beneficiary can keep the difference between the return and the interest rate tax-free.
Consider shifting income to younger generations, who may be in lower tax brackets, or making trust distributions to beneficiaries who are taxed at lower rates. It may work better to avoid overly specific bequests. For instance, you could set more flexible equations to capture upper or lower limits. In other words, you might leave values or percentages, such as $100,000 or 25% of the estate, whichever amount is less. Executors could make more efficient distributions that way as the market zigs and zags.
Changing horses midstream
You might also switch to some of these structures.
GRATs are great: A grantor retained annuity trust is irrevocable. The grantor contributes an amount to the trust for a specified period. The interest rate is set by the IRS. The grantor receives back the principal and interest at the end of the payback term, paying no gift tax. Better yet, any amounts that exceed the initial contribution and interest can be relayed untaxed to beneficiaries. Last, during the GRAT period, the grantor pays tax on the gains, while the assets keep increasing. If you get the timing right and the assets grow handsomely during the GRAT period, you can transfer significant amounts without incurring gift tax.
Roth conversions get ruthless: In 2019, Congress passed the SECURE Act, ending provisions that allowed individuals to stretch IRA benefits over several generations. Now those who inherit IRAs must withdraw the holdings over 10 years. Yet if you convert a traditional IRA to a Roth IRA, the assets can continue to grow tax-free for generations. Conversions can be expensive, but the silver lining is that when asset values are down, conversion taxes are likewise lower.
A flexible flaw: An IDGT (intentionally defective grantor trust) sounds suspiciously lacking! Why is it defective? Assets are removed from an irrevocable trust, yet the grantor still pays tax on the trust income during their lifetime. (That is the so-called defect.) The value of the estate is lowered, and gift taxes are avoided.
These strategies can help your estate and beneficiaries minimize taxes. They are complex, though, so be sure to explore the ins and outs thoroughly with your attorney or financial planning adviser.
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