How To Estate Plan During Market Fluctuations And High Inflation

By: Randall A. Denha, J.D., LL.M.

Earlier this year the stock market entered bear market territory. The typical benchmark for a bear market is if the market comes down at least 20% from its high mark. This could be spread out over the stock market in general or a specific index like the S&P; 500 or Nasdaq. You could also have a bear market in specific sectors, such as tech, or commodities, such as oil or gold. There isn’t a set duration for the decline, which means it could last weeks or even months depending on specific market conditions.

Many reasons exist for our current market decline such as declining company earnings, political issues, layoffs, inflation, interest rate increases, COVID pandemic and the war in Ukraine. Despite all of this, estate planning should be front and center with a view on creating new opportunities and taking advantage of this current climate by utilizing some of the following planning strategies:

• Annual Exclusion Gifting. You can give up to $16,000 to someone in a year and not have to worry about paying gift taxes on it. The current values of most stock portfolios have likely taken a beating along with the overall stock market. This is an opportunity to take advantage of the stock drop to gift your property at a lower valuation. If you think that the stock price is likely to come back, you can gift it now, and your beneficiaries will be able to take advantage of the increase when that happens. This gives more to others who you want to get your assets and keeps the stock out of your estate. Thus, your estate’s tax obligations are lowered

• Grantor Retained Annuity Trusts (GRATs). While interest rates have increased, they still remain low as the Fed tries to jump-start the economy. This makes a Grantor Retained Annuity Trust a more advantageous option. In a GRAT, you deposit certain property into a trust for a fixed period of time. While the trust is in effect, you will receive fixed payments based on the fair market value of the property in the trust. Not only is this a way to transfer property at a reduced price, but it also becomes more attractive when interest rates are lower. This is because it affects the fixed payments that are payable. The lower the interest rates, the lower the payments to you, which makes the GRAT more effective as a means of tax-free wealth transfer. The GRAT will lower your estate’s tax obligations and can keep you from owing gift taxes on transfers.

• Qualified Personal Residence Trust. A Qualified Personal Residence Trust is another way to take advantage of a depressed asset price and freeze the value in place for future tax considerations. This type of trust would also be aimed at reducing tax obligations. The QPRT works to reduce the size of your taxable estate because it allows you to transfer the full value of the residence out of your taxable estate at a gift tax cost equal only to the remainder value of the residence taking into consideration your right to continue living in the residence for a period of years. The higher the IRS interest rate, the higher the imputed value of your retained right of occupancy, and the less that is deemed transferred as a gift to your family. You would be taking advantage of the lower price of the house when you put it into a trust and transfer it to your beneficiaries. They would not be responsible for taxes on the increase in price as the house recovers in value when the market turns around. This does not mean that you would have to move out of your house and find somewhere else to live. The trust would have a set term where you could stay in the home without paying rent. When that term expires, you would need to pay rent to your children.

• Charitable Remainder Unitrusts. If you have charitable inclinations, you may also want to consider a Charitable Remainder Unitrust (a “CRUT”), which is favorable under the current conditions for similar reasons as described above regarding a QPRT.A CRUT is an irrevocable trust established during your lifetime which provides annual distributions to you or to selected beneficiaries during your lifetimes or for a fixed term of years. The assets remaining in the trust at the end of the term are then distributed to chosen charitable beneficiaries. You will be entitled to a charitable income tax deduction in the year you make a contribution to the trust in an amount equal to the actuarial value of the assets which will ultimately pass to charity at the end of the CRUT term. The deduction is calculated taking into account the IRS interest rates in the month the trust is funded (or the prior two months). Higher interest rates increase the imputed value of the remainder interest passing to charity, leading to a larger charitable deduction. An added advantage of a CRUT is that the transferred assets are also exempt from capital gains tax on the sale of those assets. Depending on how the CRUT is structured, the full value of the trust, or the actuarial value of the remainder interest, may be entitled to an estate tax charitable deduction.

• Roth Conversions. Roth IRA conversions are a great way to transfer money from a traditional taxable IRA to a tax-free Roth IRA. However, when you complete this conversion under normal market conditions, you’re typically on the hook for a significant amount of taxes on your investments. You can save money on a Roth conversion by completing it during a market downturn. Because the value of your investments is lower during a decline in the market, you’ll pay a smaller amount of taxes when you make the conversion. It’s also a good strategy if your income is lower than it usually is in a given year. Depending on your 401(k)/403(b) plan rules, you may be able to complete this same strategy inside of your qualified plan(s) as well.

• Substitute Assets in Irrevocable Trusts for Estate Tax and/or Income Tax Basis Planning. Given the depressed markets, you should review the value (and basis) of assets already funded in irrevocable trusts. If the trust terms include a power to substitute assets, it may be advantageous to swap out certain low-basis assets in those trusts with assets currently in your taxable estate, so that those low-basis assets are eligible to receive a step up in basis for income tax purposes at death. Alternatively, if the trust does not include a substitute or swap power, so long as the trust is a “grantor trust” for income tax purposes, low basis assets could be purchased out of the trust by the donor.

• Invest Your Cash. While the cost of living is climbing at an annual rate of 9.1 percent—the biggest monthly increase in more than 40 years—most savings rates are still well below 1 percent. That means your cash is rapidly losing value. So it’s time to develop a new strategy for where you keep your money.

The Federal Reserve is hiking interest rates more rapidly to slow inflation, most recently with a 0.75 percentage point increase. Banks have started to raise their own deposit rates, but they often move slowly and the increases tend to be small. The savings account rate recently has averaged about 0.10 percent.

In an inflationary period, the value of cash goes down. A dollar buys less and less with every passing year. On the other hand, stocks and stock markets generally trend upward, but as of late, some folks simply prefer cash and not interested in any market risk. As such, here are a few options for investing cash while still maintaining liquidity:

1. Treasury Bills.  Treasury bills are short-term securities, which means they come with shorter maturity dates than bonds and notes. Certain types of T-bills have a maturity period of just a few days, but they’re typically issued in terms of four, 13, 26 or 52 weeks. T-bills are assigned a specific face value, such as $1,000, $5,000 or $10,000, but you can usually purchase them for less than that. The amount you pay is called the discount rate. Once the securities mature, the government hands over the full amount of the bill. Here’s an example of how the process works. Let’s say you purchase a $10,000 T-bill with a discount rate of 3% that matures after 52 weeks. That means you pay $9,700 for the T-bill upfront. Once the year is up, you get back your initial investment plus another $300.
2. Certificates of Deposit.  A certificate of deposit (CD) is a low-risk savings tool that can boost the amount you earn in interest while keeping your money invested in a relatively safe way.  In exchange for depositing your money into a bank for a fixed period (usually called the term or duration), the bank pays a fixed interest rate that’s typically higher than the rates offered on savings accounts. When the term is up (or when the CD matures), you get back the money you deposited (the principal) plus any interest that has accrued. If you need to access your funds before the CD’s term ends, you are subject to an early withdrawal penalty, which can significantly reduce the interest you earned on the CD.
3. I-Bonds. These may not be a handy source of cash, but they’re a great option for those who can afford to lock up their money for at least a year. These government savings bonds pay inflation-adjusted interest rates, most recently an annual 9.62 percent, or a guaranteed 4.81 percent over the next six months. (If you make a withdrawal within five years, you lose three months of interest.)