Opportunity Amid Uncertainty

The combination of market volatility and low, but quickly rising interest rates, is unsettling for even the most sophisticated investors.

Extreme market volatility can feel overwhelming and chaotic, particularly when the advice you receive is to resist taking action in your portfolio and remain committed to your long-term asset allocation plan.

But there are several actions you can take outside of making major portfolio moves. In fact, certain wealth planning strategies can be even more effective during market corrections. Other strategies should be considered when interest rates are low and yet others after they increase.

Below, we explore several of these strategies, which may be valuable to consider in the current environment.

Planning Amid Volatility

When markets “correct,” as they do from time to time, there are wealth planning strategies that can be even more effective than in an “up” market. Gifting assets at depressed values while interest rates are still relatively low is one such strategy.

Federal Gift and Estate Tax Exemption

Even if you used your entire exemption as of 2021 ($11.7 million per individual), the per-person inflation adjustment granted in 2022 permits you to gift another $360,000 tax free (for a total of $12.06 million per individual). Gifts of assets that have dipped in value (e.g., marketable securities) more effectively leverage this exemption, so when markets recover, any increase in value will occur outside of your taxable estate.

Grantor Retained Annuity Trust (GRAT)

A GRAT is a type of irrevocable trust where grantors can place appreciating assets in the trust in exchange for receiving fixed payments for a period of time. It offers a valuable opportunity to transfer excess investment return to beneficiaries with little or no gift tax. Appreciation over a hurdle rate, known as the Section 7520 rate, accrues to the trust beneficiaries. It is a particularly effective technique at lower interest rates and market values because the “hurdle” rate above which excess return must be generated is lower, and price appreciation potential is greater. Any security or other asset that has significantly decreased in value may be a strategic asset to fund a GRAT because, if the value rebounds, the excess appreciation will benefit the beneficiaries gift and estate tax-free.

Income Tax Opportunities

Depressed asset values present opportunities for income tax savings as well. For example, you might consider:

Harvesting tax losses to take advantage of depressed markets by selling assets at a loss to offset the tax liability from selling assets at a gain.
Increasing contributions to tax-advantaged retirement plans and encouraging children to contribute to Roth accounts, if eligible.
A Roth conversion. If you convert a traditional IRA to a Roth IRA when values are low, you pay less taxes on the conversion. As the market recovers, any increase in value of the assets in the account will be free from income tax when distributed.

Installment Sales to an Intentionally Defective Grantor Trust (IDGT)

Similar to GRATs, IDGTs freeze the value of taxable assets in your estate and shift excess return to trust beneficiaries by selling appreciating assets to the trust in exchange for a promissory note. The IDGT pays an income stream to the donor for the term of the note with an interest rate at or above a minimum rate published by the IRS. After payment of the note, interest in excess of the prescribed rate is transferred to the trust for the benefit of family members gift and estate tax-free. This strategy works particularly well for business assets that will appreciate or be sold.

Swap Powers

Many irrevocable trusts, including GRATs & IDGTs, contain a power of substitution, which allows you to swap appreciated assets with depressed values in the trust with new assets from the trust creator in order to exclude future appreciation from the estate. Review existing GRATs and IDGTs that may not be working as intended because of the recent market downturn. You may be able to substitute low value assets with cash or other assets in order to use those depressed value assets to “start over” by creating a new GRAT or IDGT.

Charitable Lead Annuity Trust (CLAT)

Similar to a GRAT, a CLAT is designed to shift assets to family members in a tax-efficient manner. However, the annuity is paid to a charity rather than the donor. Any amount over the 7520 rate transfers to children at the end of the trust term without gift or estate tax.

Making the Most of Low, but Rising, Interest Rates

Though low interest rates can certainly be a headwind for investors, taking advantage of these strategies can help fortify your wealth plan in a shifting interest rate environment. These strategies offer opportunities to maintain portfolio growth while still achieving your financial goals.

But the time to act is now. Consider the difference between funding a five-year, $5 million GRAT with a 5.6% expected rate of return in December 2021, when the 7520 rate was at 1.6%, versus June 2022, during which time the rate more than doubled to 3.6%.

At the end of the five-year term for a GRAT established in December 2021, the remainder available to beneficiaries could be over $380K more than the same five-year GRAT funded just six months later.

As interest rates continue to climb, there are a different set of wealth planning strategies that become effective to satisfy different goals and objectives. For example:

Qualified Personal Residence Trust (QPRT). A QPRT is designed to gift an interest in a personal residence or a vacation home while retaining the right to the exclusive use of the residence for a term of years. After the term of years, the residence passes to remainder beneficiaries at a lower taxable value than if you gifted the home outright. In a higher interest rate environment, the value of the retained interest is deemed to be higher and the value of the gift of the remainder interest is less, often resulting in more tax savings.
Charitable Remainder Annuity Trust (CRAT). A CRAT is essentially the reverse of the CLAT described above. With a CRAT, annuity amounts are made annually to individuals for a specified term and, at the end of the term, pay the remainder interest to a charity. Higher interest rates are preferable since they result in a higher annuity payout to the noncharitable beneficiary.

Review and Optimize Your Plan

While the current period of market stress is unsettling, it provides the opportunity to review and optimize your wealth plan by implementing strategies to help achieve your goals. It also highlights the importance of having a plan that engenders confidence and positions you to fund your highest priority goals during market downturns. Speak with a Northern Trust advisor today to see how these strategies may improve your plan.

Wealth Planning