The rapidly evolving coronavirus (COVID-19) crisis is creating challenges across our world. With all the tragic things that are happening as a result of the outbreak, now might seem like an unusual time to talk about opportunity. Now, more than ever, is the time for us to be proactive about creating small moments of happiness, given that positive emotions help to counteract the negative effects of stress. Now is the opportunity to spend quality time with our loved ones during social distancing and sheltering-in-place. It also creates some unique wealth planning opportunities, particularly given the volatility of the financial markets and the low interest rate environment.
Transfer Tax Planning
- Basic Estate Planning. Now more than ever we need to focus on our wellbeing and that of our families. As part of this process you should review your current estate plan to ensure that you have at least your basic documents in order (Wills, Revocable Trusts, Powers of Attorney, beneficiary designations and health care directives) and that these documents reflect your current wishes.
- Efficient Wealth Transfer Strategies. Given the volatility of the financial markets, depressed asset values and historically low interest rates you should consider this an ideal time to transfer wealth to your intended beneficiaries.
The Applicable Federal Rate and the §7520 Rate
Each month, the Internal Revenue Service publishes short-, mid-, and long-term rates (the Applicable Federal Rates, or AFRs) and the §7520 rate. The AFRs reflect the minimum interest rate that must be charged for loans between related parties; the §7520 rate, which is 120% of the mid-term AFR, is used to calculate annual payments for certain estate planning techniques including Grantor Retained Annuity Trust (GRATs, and Charitable Lead Annuity Trust (CLATs). These rates are calculated based on the yields of certain government debt obligations, and the target federal funds rate has a direct impact on these yields. Since the AFR and the §7520 rate are used when implementing many estate planning techniques, the efficacy of these techniques change when the rates change. In a falling environment, the choice is whether to lock in current rates, or wait for rates to fall to even lower values.
These rates are currently at or near historic lows, presenting several estate planning opportunities.
Below is a brief outline of a few strategies you might want to consider.
- Intra-Family Loans/Sales. The simplest strategy in a low interest rate environment are intra-family loans/sales where the senior family member lends or sells assets to junior family members. The loan can be structured as an interest-only loan with a balloon payment on maturity. This strategy can be very effective because the loaned or sold assets only need to appreciate at a rate greater than the interest rate charged (relevant AFR). In such cases, the appreciation above the AFR passes to the next generation or trusts for their benefit transfer tax free. The value of the loaned or sold assets will be based on a fair market value valuation, which may include discounts for certain factors. Given market conditions, we anticipate the fair market value of many assets will be depressed and discounted. With this strategy, when asset values rebound all that appreciation will be outside of your taxable estate and will be held by or for the benefit of your intended beneficiaries transfer tax free. These techniques enable senior family members to “freeze” the value of the assets that they lend for estate tax purposes; and pass the asset’s appreciation to the next generation of family member or trusts for their benefit.
- $1 Million Private/Family Loan Example:
*Assumes 7% growth on loaned assets less interest paid. Using appreciated assets to repay the loan could cause a capital gain. This illustration does not take income tax attributable to loan interest or income tax on capital gains into consideration.
- Installment sale to an Intentionally Defective Grantor Trust (IDGT): This is similar to an intra-family loan. This is an installment sale to an irrevocable “grantor trust” in exchange for an interest-bearing note. The note is typically interest-only with a balloon principal payment at the end of the note term. The grantor trust is treated differently for income and transfer/estate tax purposes. No gain is recognized on the initial sale. For income tax purposes, the grantor is responsible for any income tax, including capital gains tax, incurred by the trust. The asset sold to the trust is often a non-cash asset. Because the lender is required to pay the trust’s income tax liability, the sold assets can grow inside the trust on an income-tax-free basis; in addition, the asset appreciation over the interest rate (AFR) accrues to the trust beneficiaries free of gift tax. Your estate includes only the face amount of the note. This can be a very efficient generation-skipping transfer planning vehicle.
*Assumes 8% growth and 2% income on transferred assets
- Grantor Retained Annuity Trust (GRAT). A Grantor Retained Annuity Trust (GRAT) is an estate planning technique in which the grantor makes an irrevocable gift to a trust, while retaining an income stream in the form of an annuity. The term of the GRAT may be for life or any period not less than two years that is determined at the inception of the trust. In order to achieve the best tax results, a specified term of years is typically used. At the end of the term, the GRAT's remaining assets will be distributed to the individuals or trusts named as remainder beneficiaries. The IRS values the ultimate transfer of assets based on the value of the annuity stream you retain and an assumed rate of return on such assets. The assumed rate of return is mandated by the IRS (and is commonly known as the 7520 rate). The current 7520 rate is 1.2%. As such, if you retain the right to receive an annuity stream from the Trust equal to the value of the assets contributed plus a 1.2% rate of return, any assets remaining in the Trust at the end of the term, will pass to your intended beneficiaries transfer tax free (this is known as a "zeroed-out GRAT"). If the assets outperform the 1.2% assumed rate of return, all such excess will escape estate taxation. Again, given this low hurdle rate and depressed asset values, GRATs should be seriously considered by anyone looking for an effective way to transfer assets to younger generations.
$1 Million GRAT Example:
John and Susan would like to transfer assets to their children but have already used their lifetime gift tax exemption. They would like to avoid paying any gift tax when the transfer is made. The GRAT is designed so John and Susan will receive annual distributions from the trust, pass on the remaining assets to the children in 10 years, and avoid being subject to gift tax.
10-Year, $1 Million Grantor Retained Annuity Trust*
*"Zeroed-out" 10-year GRAT initially funded with $1 million. Assumes 2% income and 5% growth on GRAT principal.
- Charitable Lead Annuity Trusts. Families that wish to financially support the missions of charitable organizations may seek to maximize the tax advantages of their charitable gifts. For those who plan to make consistent annual charitable gifts, a Charitable Lead Annuity Trust (CLAT) may provide several advantages. One of the tax benefits of a CLAT could allow the donor to receive a current-year income tax deduction for charitable gifts that will be made in the future. Like a GRAT, in a CLAT, you, as Grantor, transfer assets to a Trust in which a charity is designated to receive an annuity stream for a term of years. At the end of the term of years, the balance of the assets remaining in the Trust pass to the beneficiaries you indicate in the Trust Agreement. As with a GRAT, it is possible to structure a CLAT such that the balance of the Trust assets pass to your intended beneficiaries transfer tax-free. The value of the assets ultimately passing to your intended beneficiaries is determined by subtracting the value of the annuity stream the charity receives from the value of the assets at the time the CLAT is funded. The value of the annuity stream passing to the charity is also affected by the 7520 rate, the lower the 7520 rate, the higher the present value of the annuity passing to the charity. Again, depressed values and the low-interest rate environment result in more assets passing to your intended beneficiaries transfer tax free.
Jane, a 65-year-old widow, has regularly supported charitable organizations. Jane has an estate that will be subject to the federal estate tax. Jane would like to continue giving $56,000 each year to charity for the next 20 years, and, following the term period, she would like to pass the property to her children and pay the least amount of estate tax. Jane plans to accomplish these goals by contributing $1 million to a 20 year 5.653% CLAT, with $56,000 distributed to charity annually and the remainder passing to her children after 20 years without a federal estate tax being paid on these assets. Jane may also be able to take advantage of a current year income tax deduction, even though most of the payments to charity will not be made until future years.
$1 Million Lifetime Charitable Lead Annuity Trust*
*Assumes trust has a 7% total return. To potentially receive a charitable deduction for the present value of the annuity in the year the CLAT is created, the trust must be a granter trust and Jane will report the CLAT's income on her income tax returns and pay the associated income tax. The income tax consequences to Jane are not illustrated in the above example.
- Roth Conversions: As many individuals become more concerned about the impact of taxes in retirement, Roth IRAs present a unique retirement vehicle to consider. A Roth conversion is a taxable transfer of amounts from an eligible retirement account, such as a Traditional IRA or 401(k), to a Roth IRA. When you convert your eligible retirement account to a Roth IRA, you will pay income tax on the taxable amount converted in exchange for tax free growth and distributions in the future. If you can pay the tax due on conversion from a taxable account, more wealth is transferred into tax-free accounts. Depressed values of existing IRA balances may reduce the taxable income that otherwise would have been due. If the market recovers, the market gain will be tax-free.
- Growth is tax-free for qualified distributions (generally age 59 ½ or older and more than 5 years of contributions, with an exception for contributory IRAs, see below);
- Roth IRAs are not subject to Required Minimum Distributions (RMDs), so you don’t have to take distributions at age 72 (remember the new law, SECURE). You can accumulate without distribution until your death, and your spouse’s death.
- The new SECURE Act mandates distributions to non-spouse heirs of inherited IRAs over ten years, rather than the previous and much more advantageous ‘stretch’ provisions. A Roth IRA allows children of inherited IRA owners to grow the inherited Roth tax-free for ten years past the date of the death of the last spouse.
SECURE Act: The compressed withdrawal period has the potential to shift beneficiaries into higher tax brackets and ultimately leave them with a smaller inheritance than under prior “stretch” laws that allowed them to withdraw funds over their lifetimes. While withdrawal within 10 years of the account owner’s death is still required for Roth IRAs, Roth distributions are tax free and therefore do not have the same tax impact on beneficiaries. Using Roth Conversions may therefore be beneficial to you and your heirs.
The Ideal Candidates for Conversion:
- Don’t expect a significant decline in their marginal tax rates in retirement.
- Can afford to pay the income tax on conversion from other assets.
- Intend to transfer their Roth IRA at death to beneficiaries who will “stretch” it.
- Can afford to use other assets for living expenses at retirement and allow the Roth IRA to grow (or begin taking distributions much later in retirement)
- Taxpayer will have lower taxable income in the year of conversion
- Net Operating Losses (NOLs)
- Charitable Deduction Carryforwards or Large Charitable Deduction (CLAT)
Consider Estate Taxes.
By paying the income tax up-front, the size of the estate is reduced. Pre-payment of the income tax is essentially a tax-free gift to heirs. A Roth IRA is a better asset to fund the credit shelter trust than a Traditional IRA because qualified distributions are income tax free and do not waste part of the unified credit.
To Convert or Not? Weigh the advantages and disadvantages of converting a Traditional IRA to a Roth IRA.
- Determine whether the loss of the use of the money spent on taxes today is less than the present value of the future tax savings from the Roth distributions.
- Financial analysis should consider any multi-generational benefits
- Sequoia can help you determine if there is a reasonable expectation that the benefits of “pre-paying” taxes via a Roth IRA conversion make sense in your overall financial and estate plan.
Roth Example $1 Million
Tom, a 65-year-old, has an estate that will be subject to the federal estate tax. The value of Tom’s IRA is depressed because of the recent market declines. Tom expects the market will rebound once the COVID-19 pandemic comes to an end. Tom does not need retirement income and would like to pass an income tax-free inheritance to children with the least amount of estate tax. Tom does not expect his tax bracket to be lower in retirement and can afford to pay the income tax on conversion from other assets. Tom decides to open a new Roth IRA account with the current trustee and does a trustee-to-trustee transfer of $1,000,000 from his IRA to his new Roth IRA.
1 Assumes a life expectancy to age 90 and the IRA and Roth IRA are distributed to the children 10 years after date of death.
2 Assumes the IRA and Roth IRA have a 70/30 investment objective and a 6.02% rate of return.
Assumes 42% Marginal tax bracket.
3 Assumes the discount rate to calculate present value is the assumed inflation rate of 2.01%
4 Assume a 40% estate tax rate
5 Assume a market rebound in 2020 of 10% and 20% in 2021 (in addition to the 6.02% ROR)
Today’s low interest rates and a depressed market may provide an opportunity to help you effectively achieve your wealth transfer and legacy planning goals. Now may be a good time to discuss these opportunities with your Sequoia Advisor. It is important to seek the advice of a professional advisor familiar with your specific goals and financial situation before engaging in any strategy.
For more information on this topic contact Michael Cymbal.