Wealth Management Strategies for the COVID-19 Crisis
As markets have sold off from their February highs and interest rates have touched all-time lows due to the COVID-19 pandemic and economic contraction, there are unique financial planning and wealth management opportunities high net worth families might want to consider. Moreover, as the TCJA tax cuts are set to expire in 2026, careful long-term planning is imperative. Here are a few financial planning ideas that may be particularly relevant for wealthy families given the market turmoil, the low interest rate environment, and the current tax environment.
Consider Roth Conversions for the Current Tax Climate
In the current environment, it may make sense to do Roth Conversions, which involves converting pre-tax IRA balances into tax-free Roth IRA balances while paying the related income taxes. Once the funds are in the Roth IRA, all future growth and distributions are tax-free as long as you meet the holding period requirements. With IRA balances at depressed values, Roth Conversions are more attractive due to the lower tax impact. Moreover, given the COVID-19 economic contraction, many families are in a lower tax bracket for 2020, which will lower the cost of the conversion. Also, we expect the highest marginal rate to increase when the TCJA tax cuts phase out on 1/1/2026 or earlier if Democrats make big gains in Washington in November.
Planning to Wealth is a big believer in having tax diversification between various taxable brokerage accounts, tax-deferred IRAs and 401K(s), and tax-exempt accounts like Roth IRAs. For those that might have large IRA balances relative to Roth IRA balances, 2020 might be the year to convert some of your regular IRA balances to Roth IRA to be more diversified from a tax perspective. Converting Roth IRA balances has several benefits when distributing assets from your accounts in retirement. The required minimum distributions (RMDs) would be lower in retirement, which lowers taxes and potentially lowers Medicare premiums as well.
Combat the Death of the “Stretch IRA”
The Secure Act from December 2020 implemented a “10-year rule” on non-spousal beneficiaries for IRAs, 401K(s), and other qualified plans. This is a potentially serious tax issue for families with large IRAs and qualified plans. No longer can families do a “stretch IRA” wherein the second generation was able to take distributions from inherited IRAs over potentially decades to maximize compounding, delay taxable distributions, and minimize the tax bracket impact. Most non-spousal beneficiaries now have 10 years to take distributions from inherited IRAs. This is most impactful for two types of beneficiaries: 1) 20-something and 30-something beneficiaries that aren’t likely prepared to handle immediate access to large IRAs and 2) beneficiaries in their 40’s, 50’s and early 60’s which will have to take distributions potentially during their peak income years in a compressed time frame.
As well, many families with trusts as beneficiaries will have to restructure their documents to comply with the new regulations. There are several strategies to minimize the impact of this new 10-year distribution rule including consistently doing Roth conversions over time to reduce the size of IRA balances, naming charitable remainder trusts as IRA beneficiaries to spread out the distribution of income, and naming non-spouses as partial beneficiaries to start the 10-year clock sooner to minimize bracket impact.
Consider Grantor Retained Annuity Trusts (GRATs) to Minimize Transfer Taxes
If used effectively, GRATs can be used to mitigate estate and gift taxes. The Section 7520 rate reset to an all-time low of 80 basis points for May 2020, which makes GRATs more attractive as an “estate freeze” strategy. Essentially, it only takes returns above this very low hurdle rate to be effective in this environment. For example, a 2-year $1 million GRAT that earns 5% each year will result in $65,000 being transferred to the beneficiary without transfer taxes or using any of the lifetime gift exemption. Given that gifted assets don’t receive a step-up in basis like inherited assets do, it probably makes sense to use assets with a relatively high basis for GRATs.
While most high net worth families don’t have to consider estate and gift taxes since they are below the $11.58 million estate tax exemption and lifetime gift tax exemptions ($23.16 million for married couples), the exemption amounts will revert to $5 million (adjusted for inflation) per person in 2026. Moreover, many families still have to worry about state estate and inheritance taxes. For example, estates in New York State over $5.85 million in 2020 are subject to estate tax rates of up to 16%.
Gifting Assets and Business Interests to Take Advantage of Low Valuations
For families planning on gifting assets, including business interests, to the next generation, they might want to accelerate their plans given current depressed valuations. More shares and assets, in theory, can be passed by the $15,000 annual gift exclusion in this economic environment. Wealthy families that want to transfer business interest to the next generation at discounted values through minority and marketability discounts can do so through structures like Family Limited Partnerships (FLPs) and Family LLCs (FLLC). These structures allow the owner to maintain control of the business while giving ownership to the next generation. The lower current valuations for most businesses allow potential savings on estate and gift taxes as the structures allow credit protection and potentially shifts income to lower brackets in the next generation.
The importance of gifting assets to the next generation expeditiously may increase as the high lifetime gift tax exemption is set to lapse in 2026, but could happen earlier if we see changes in the administration after the November elections.
Consider a Spousal Lifetime Access Trust (SLAT) to Minimize Transfer Taxes
For families concerned about losing the option to use the large gift tax exemption but still need access to these assets, one option might be to consider having each spouse create a Spousal Lifetime Access Trust (SLAT). In this structure, each spouse makes an irrevocable gift to a trust for the benefit of the other spouse. That way, the $11 million gift exemption could be used and the taxable estate is reduced, while at the same time the trust can be used for household expenses. Special care must be used in drafting these trusts to avoid making them mirror images of each other to avoid the reciprocal trust doctrine, which could make the trusts ignored by the IRS for tax purposes.
Low Interest Rates Make Charitable Lead Trusts (CLTs) More Attractive
For families that have charitable goals and are looking to shift assets to the next generation tax efficiently, a CLT is particularly attractive given today’s low interest rates. Today’s lower 7520 reduces the required annuity to charity, so more assets can be transferred to the next generation. As well, rules allow CLT to choose from the interest rates from the last three months, which gives the donor more flexibility.
Investigate Mortgage Refinancing to Improve Cash Flow
Frankly, refinancing rates are not what we would expect given the low interest rate environment for a variety of reasons (limited processing capacity, credit concerns, rules around the timely processing of applications, bank balance sheets concerns, etc.). However, it still may make sense to look at options in this environment.
Implement Tax Loss Selling to Reduce Tax Liability
It may make sense to evaluate the cost basis of each of your brokerage positions to see if it makes sense to take tax losses to offset future capital gains and then repurchase similar investments to stay invested. It’s important to be careful of the “wash sale” rules which will disallow any loss you locked in if you repurchase the security within 30 days. The losses can offset capital gains in the current year and $3,000 of ordinary income in the current year. If you’ve locked in losses in excess of that, then you use them against capital gains in future years.
Intra-Family Loans
Intra-family loans are another way to use currently low interest rates to reduce transfer taxes. Parents could lend funds to the next generation or other family members through a trust or for a specific use at the minimum IRS mandated rate, which is incredibly low: 0.25% for loans under 3 years, 0.58% for loans between 3 and 9 years, and 1.15% for loans over 9 years. Any rate of return on the investment of the loaned funds above the AFR rate essentially passes to that family member and escapes transfer taxes. Documentation is key on this, so please work with your CPA or advisor so that this is done correctly.
Overall, from Roth conversions to gifting assets and business interests, there are many wealth management strategies that high net worth families can leverage given the market turmoil, the low interest rate environment, and the current tax environment as a result of the COVID-19 pandemic. While this is a stressful time filled with uncertainty for many, it’s important to take this time and reset your financial plan to ensure a bright future for your family.
David Flores Wilson, CFP®, CFA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.