Planning Techniques for Bear Markets
Has your portfolio dropped significantly? What can you do? Watching your portfolio’s value tumble in the midst of a bear market can be mentally and emotionally draining. You might even wish to ignore your portfolio completely during a market downturn. While bear markets are generally unfavorable, they can provide an advantageous opportunity for various financial and estate planning strategies. Strategies such as tax loss harvesting, Roth conversions, 529 plan contributions, gifting assets, and setting up Grantor Retained Annuity Trusts (GRATs) can help you save money on taxes and efficiently remove assets from your estate.
Tax Loss Harvesting/Swaps: Tax loss harvesting is a technique that involves selling a security in a taxable account (trust, joint, and individual accounts) with an embedded loss. Realized losses are used to offset any realized capital gains in a given tax year. If there are more capital losses than there are gains, then losses can be used to offset ordinary income up to $3,000 per year. Unused realized capital losses are carried forward indefinitely to be used against capital gains and ordinary income in upcoming years. WESCAP has implemented numerus tax swaps for our clients as appropriate during the most recent market declines and will continue to actively search for future tax loss harvesting opportunities.
IRA Roth Conversions: Roth IRA accounts are excellent for achieving long-term, tax-free growth of assets. Later withdrawals are tax-free as well. Bear markets reduce the value of assets transferred from an IRA to a Roth IRA. Post bear market, when asset prices have rebounded, you have successfully shifted the growth from your pretax account to your Roth IRA, getting a head start on the long-term compounding of growth. One caveat of this strategy is that cash will be needed to pay for the income tax associated with the Roth IRA conversion.
529 Plan Contributions: Contributing to a 529 plan during a bear market offers similar advantages as the Roth IRA conversion. If assets are bought during a period of market decline and prices later rebound, then you have increased the funds that can be withdrawn tax-free when used for qualified education expenses of the beneficiary. Contributions to 529 plans are considered completed gifts for federal gift taxes (see next section), however, 529 contributions can be front-loaded using the 5-year election on Form 709.
Gifts to Family & Friends: The annual federal gift tax exclusion is currently $16,000 per donor to each recipient, meaning spouses together can gift $32,000 to a receiving individual. Gifts over the $16,000 annual limit will require you to file Form 709 on your tax return and will reduce your available lifetime gift exclusion, currently $12,060,000 per person. During a bear market, more assets can be gifted that may ultimately appreciate and represent a larger dollar value in the future. Taking advantage of the $16,000 annual gift exclusion is a great way to transfer assets and reduce your estate while still conserving your lifetime gift exclusion. Do not transfer assets at a tax loss however (see tax loss harvesting above).
Grantor-Retained Annuity Trusts (GRATs): In a grantor-retained annuity trust, or GRAT, assets with high potential for growth are placed into an irrevocable trust for a fixed number of years. The grantor of the trust retains the right a fixed annual payment, usually equal to the principal and the stated IRS Section 7520 interest rate (currently 3.8%). At the end of the period any remaining assets are passed to the beneficiaries, estate and gift tax free.
Transferring assets to a GRAT when they have declined in value due to a bear market allows for a higher value going to the beneficiaries, assuming the assets rebound, similar to the Roth IRA conversion strategy discussed above.
Additionally, it removes the growth of these assets from your estate. The current estate and gift tax exemptions are scheduled to decrease back to their much lower original levels with the end of the Tax Cuts and Jobs Act in 12/31/2025. A decrease in estate tax exemption levels will leave more people in need of gift and estate planning to avoid the accompanying harsh 40% estate tax rate.
A drawback of GRATs, and all irrevocable trusts, is that assets transferred into them will not receive a step-up in cost basis at the grantor’s death. If the GRAT heirs plan to sell assets later they may owe a large capital gain tax. Hence GRATs are best used for estates that otherwise would face even higher estate taxes or for heirs that do not plan on selling the assets
GRATs are typically set up as short-term trusts because if you pass away before the period is over the assets revert back to your estate. The assets transferred into a GRAT are normally selected to represent a specific sector, class, or a single security, so that the probability of a very large gain is improved and more value is ultimately transferred to heirs. However, if the chosen asset does poorly instead, the GRAT can be created with a provision that allows for assets of equal value to be swapped in and out of the trust. In the case of a poorly performing GRAT, you could swap the poorly performing assets with treasuries or cash and set up a new GRAT with the same or different assets, starting the process over again.
The most common strategy is a “zeroed-out” GRAT, where the grantor receives annual annuity payments where the annuity’s present value is equal to the original value transferred into the trust plus the implied 7520 interest rate. As a result, there is no gift tax associated with “zeroed-out” GRAT.
Both President Obama and President Biden have proposed tax law changes to GRATs that would reduce their usefulness. So far, these proposals have not been enacted. If tax law changes are made to GRATs, older GRATs may have some provisions grandfathered in and other provisions may not be grandfathered in.
Some detailed examples and more explanation about GRATs can be found here:
Expert estate attorney advice should be sought if considering a GRAT.
As always, please feel free to contact WESCAP at (818)563-5170 if you would like to discuss any of this further.