Our conversations with clients usually cover topics that range beyond investment and financial affairs. That has rarely been truer than during the past month or so as the COVID-19 outbreak has spread across the world, and as we have been talking to you about your health and well-being, your families, friends and communities, and about the adjustment to the new social distancing protocols that are transforming our daily lives.
Of course, given the market volatility that has accompanied this outbreak, we are also reviewing where we stand in relation to the goals we are helping you pursue and the plans we have helped you implement. Although these times are stressful, and the road to recovery for markets and society is unlikely to follow a straight line, we are hearing from many of our clients that forward-looking activity is top of mind, with specific interest in opportunities to benefit their family and the charities and communities that are important to them. These longer-term thoughts haven’t been expressed in any sort of competition with the immediate concerns of the moment; but rather spring from a desire to know that they have taken sound steps forward at a difficult time.
We are working to help you take those steps forward. We believe that the current environment offers a number of strategic planning opportunities to improve your financial plan, enhance wealth transfers to heirs or charities, minimize the impact of income taxes and broadly help you advance your progress toward long-term goals. These planning opportunities are driven primarily by four factors:
- Materially lower market values for publicly traded securities, and a likely downturn in valuations of real estate and other illiquid assets.
- Declining interest rates, which in turn lessen the “applicable federal rates” which govern intra-family lending and other estate planning structures for efficient wealth transfers and charitable legacies.
- Possible future increases in income and wealth transfer taxes, including the potential reversion of certain elements of the U.S. tax code that are not permanent.
- The unprecedented size and scope of the CARES Act stimulus package signed into law in late March (see our article on the CARES Act for more information).
Lower Values in Capital Markets
It is hard to feel confident about the market’s eventual recovery when we are in the midst of a sharp decline, but the market’s history is a continual cycle of ups and downs, and we believe that the current downturn presents some positive opportunities to take steps that are consistent with your overall plan, while minimizing tax consequences.
As we reposition portfolios, there is an opportunity to harvest losses in taxable portfolios that exceed the value of any realized gains for this tax year, and a meaningful market decline allows us to “bank” losses to be used in future years if and when markets recover.
Market declines also bring opportunities to trigger valuations for income and transfer tax purposes, so that such taxes are applied to current, lower values, thereby lessening the total amount of tax ultimately paid. These strategies may include the conversion of an IRA or qualified retirement plan to a Roth IRA, because the tax consequences of such a conversion are based on asset values at the time of conversion, and any future growth in value will avoid income taxation, both within the plan and at the time of distribution to the plan beneficiary. Likewise, for clients with non-qualified stock options, it may be advisable to exercise the options and incur the income recognition now, if the stock price is currently depressed and there is strong conviction for future growth.
Many clients have not fully utilized the augmented exemptions for wealth transfer taxes (estate, gift, and generation-skipping tax) provided by the 2017 Tax Act, which will automatically expire at the end of 2025 (and which might be legislatively modified sooner). For those inclined to take advantage of these increased exemptions, the current market may facilitate gifts at substantially reduced values, thereby maximizing the utility of those exemptions.
Likewise, depressed valuations of assets with high growth potential could be the primary driver of a successful, gift tax-free wealth transfer through vehicles such as Grantor Retained Annuities Trusts (GRATs) and Charitable Lead Annuity Trusts (“CLATs”). The performance of these trusts can also be aided by a low interest rate environment.
Declining Interest Rates
While interest rates offered by banks and other lenders do not necessarily follow in lock-step the actions of the Federal Reserve, it seems likely such rates will decline over time in response to the Fed’s sharp reduction in short-term rates. Such rate reductions may provide clients with the opportunity to reduce their cost of borrowing and free up cash flow for other uses.
For example, clients with residential mortgages should consider refinancing those mortgages at lower rates to reduce monthly payments or shorten the repayment term. Some clients may initiate new mortgages to create additional available cash at a low cost of capital, and lines of credit may also be more attractive given a lower interest rate.
Declining rates also impact intra-family loans, often used by an older generation to transfer cash or other assets to a younger generation without gift tax consequences. Such loans must carry a minimum rate of interest, known as the Applicable Federal Rate (or “AFR”), which is typically lower than a true market rate of interest (for example, the AFRs for April 2020 range from 0.91% to 1.44%). An intra-family loan can provide a younger generation with investment capital that, if invested at a rate higher than the interest rate, can effectively “freeze” the value for the senior generation and create a positive wealth transfer from the older to the younger generation in an amount equal to the difference between the growth on the capital and the interest due. In a time of declining AFRs, clients may wish to consider making new intra-family loans and refinancing any existing intra-family loans.
Possible Higher Tax Rates in the U.S.
While none of us knows what a future Congress will do with respect to tax rates, it seems prudent to anticipate a potential increase in income and wealth transfer taxes in the future. Such a scenario could result from the Democrats gaining control of Congress and/or the White House, and could also play out regardless of political outcomes, as a way to pay for the CARES Act stimulus package signed into law in late March (as noted, our summary of the CARES Act can be found here).
The prospect of increased tax rates suggests implementing strategies which lock in today’s tax rates, which may mitigate the risk of higher taxes in the future. For example, a Roth conversion (mentioned above) may be advisable not only because of reduced asset values, but also because it may be better to pay income tax on the retirement assets at today’s rate than at a future, perhaps higher, rate. Similarly, if the wealth transfer tax exemptions are likely to be pulled back in the future, using those exemptions now may be advisable.
In sum, there are a variety of planning opportunities (many of which are summarized below) that we can consider together as we think about your long-term plans. In previous disruptive market periods—the 2008-09 global financial crisis, and the “dot-com” technology-driven downturn from 2000-2002—we used a proactive planning approach that helped many clients progress toward their wealth transfer, tax-efficiency and overall legacy planning goals. While no two downturns are the same, we believe this approach can again be effective in the current period. Like many of you, the immediate health and economic impacts of this crisis are foremost in our minds, but we can also look forward and recognize that steps we take today can have a meaningful impact on your investment and financial picture in the years and decades ahead.
- Home Refinance. Mortgage rates are dropping, which presents a possible opportunity to refinance home mortgage debt.
- Financial Plans. Revisiting existing plans, and their assumptions, may be appropriate.
- Roth Conversions. Given the market downturn, this may be an opportune time for a Roth conversion, which will then protect future market gains from income taxation.
- Deferral of required retirement plan distributions. Under the CARES Act, there is no requirement for retirement plan beneficiaries to take required 2020 payments from retirement plans, and waiving those withdrawals may facilitate tax-free growth of assets and the accumulation of wealth for future generations.
GIFT AND ESTATE TAX PLANNING
- Outright Gifting. While we remain in a period of heightened estate tax exemptions, the drop in securities values creates an opportunity to gift at lower valuations.
- Intra-family Note Refinance. As with interest rates, the rates used for intra-family loans have also declined. This presents an opportunity to refinance existing notes at a lower rate, or to create new notes.
- Grantor Retained Annuity Trusts. GRATs are an attractive planning vehicle in a low interest rate environment, and funding at low security valuations increases the likelihood of success of transferring wealth to family members without using gift tax exemption.
- Sales. Sales of assets (i.e. to a grantor trust) similarly remain attractive because of low interest rates and potentially low valuations.
- Charitable Giving. Many clients have made significant contributions to Donor Advised Funds over recent years. Consider relying on those for current charitable giving, and revisit additional contributions later in the year.
- Charitable Lead Annuity Trusts. CLATs should work well in this environment for the same reason GRATs are appealing. For people who make significant charitable gifts annually, a CLAT is an excellent opportunity to combine that with family giving, usually without using gift tax exemption.
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.