Financial Advice for Retirement, Social Security, IRAs and Estate Planning

How Market Fluctuations Create Planning Opportunities

Published on: May 01 2008
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Few people realize changes in the markets and economy affect estate plans. The changes create opportunities. Strategies that were not viable or were borderline in the past will preserve more wealth today. When the markets or interest rates change significantly, it is a good idea to meet with an estate planner and take a fresh look at the options.

Gift giving is more valuable after markets decline. Every person can give free of gift taxes each year up to $12,000 per recipient. (The limit is indexed for inflation.) A married couple can jointly give $24,000 per donee each year. Since the limit is a dollar amount, a greater quantity of every asset can be given when prices fall. If a mutual fund’s net asset value was $100 last year, and the fund’s NAV has declined 20%, today 150 shares can be given tax free instead of only 120 shares last year. If gifts are not made until the end of the year and the price recovers to $90, only 133.33 shares can be given tax free.

The goal of gift giving is to remove assets from the estate, especially appreciating assets. The mutual fund shares would not be owned unless there is an expectation their value will increase. More shares, and more future appreciation, are out of the estate at no tax cost if gifts are made when values are down.

Most people wait until year-end to make estate planning gifts. There are two better times to give. One time is early in the year, so there is no chance events during the year will keep the gifts from being made. Also, the appreciation and any income earned during the year are out of the estate and off the original owner’s tax return.

The other prime time to give is after asset values decline. Do not give investment assets that are worth less than their original cost (or tax basis). Those should be sold, the loss deducted, and the cash proceeds given.

On the other hand, when assets are worth more than their tax basis but have been dealt a temporary decline by the markets, it is a good time to give them. As we have seen, more can be given, and the appreciation after the gift will be out of the estate

There are strategies that leverage the power of tax-free gifts. Today’s combination of lower market values and low interest rates makes some of these leveraged strategies more attractive and powerful.

One such strategy is the grantor-retained interest trust (GRIT). In a GRIT the grantor, or trust creator, transfers property to a trust, which pays income to the grantor for life or a period of years. After the income period ends, the remainder of the trust goes to the beneficiaries named by the grantor, usually the children of the grantor.

The remainder amount that will go to the beneficiaries is a gift, subject to gift taxes when the property is transferred to the trust. Current interest rates are used to establish the value of the gift. The lower the interest rates, the smaller the value of the gift. With interest rates so low, a GRIT can be created at a far lower gift tax cost than only last year and a lower cost than after rates rise again.

Today’s low rates create a rare opportunity to remove assets from the estate at a low tax cost. A GRIT should be created with assets that are expected to appreciate. The goal is to remove assets and their future appreciation from the estate, so the strategy is most useful for assets that are expected to appreciate. The more rapid the expected appreciation, the better the assets are for the GRIT.

GRITs come in two varieties. There is the grantor-retained annuity trust (GRAT) and grantor-retained unit trust (GRUT). The GRAT pays the grantor a fixed annual amount; the GRUT pays a percentage of the trust’s assets value annually. The advantage of the GRAT is that the grantor knows how much money he or she will receive each year. A disadvantage is that the trust might earn less than the income payments for a period of time, so the trust principal will decline more rapidly than expected.

The GRUT is likely to preserve more of the principal when returns are low or asset values decline substantially, because the income payments will fluctuate with the trust value. Better for the grantor, if investment returns are good the trust appreciates over time, and the income rises.
The grantor has to decide which of these trade offs he or she prefers.

It is possible to set up a GRAT so there are no gift taxes. The interest rates used to determine the value of the gift are very low today. The annuity payout can be set high enough so that the IRS tables assume the present value of the remainder interest is zero. Yet, if the trust earns more than the assumed interest rate, there will be a remainder for the beneficiaries to inherit.

The gifts to be given either directly or through a trust should be carefully selected. When property is given either directly or through a trust, the donee takes the same basis the donor had. If an asset has appreciated significantly so that its tax basis is low, it might be preferable to hold that asset and let it be inherited through the estate. In that case, the heir would be able to increase the basis to its fair market value and sell it without paying capital gains taxes. It is best to give assets that have not appreciated significantly yet.

Another part of the estate plan to review is specific bequests of property in the will. Sometimes a specific property is left to a person because the property ?belongs? with that person for emotional or subjective reasons. Other times the specific bequest is made in the belief that it would provide a certain amount of wealth or income for the person. After the asset price upheavals of the last year, the values, income stream, and even viability of many assets have changed. The potential for such changes to occur at any time is a good reason to limit specific property bequests. Those who have specific bequests in their wills should review them now to determine if changes need to be made because the market changes mean their goals no longer will be met.

An asset should be designated as a specific bequest only when it is unique and the beneficiary should receive it regardless of the value. Examples are art, antiques, personal mementos, collections, heirlooms, and a family business. Otherwise, it is best to designate a percentage of the estate or a dollar amount for an heir.

Likewise charitable contributions should be reviewed. It is best to leave a charity a formula that is both a dollar amount and a percentage of the estate. For example, “Charity A is to receive $100,000 or 10% of the estate, whichever is less.” For individuals, state a dollar amount or a percentage of the estate. For example, “Each of my children is to receive one third of the remainder of the estate.”

With either personal bequests or charitable gifts in the will, it is best to leave it up to the executor to decide whether to give cash or specific assets. The executor should be in a better position to decide which assets to sell and which to transfer to different beneficiaries instead of cash.

Low interest and no interest loans to family members also are good strategies when interest rates are low. The tax law imputes a minimum interest rate on loans above certain exempt amounts if one is not stated in the loan. The rate changes each month and depends on the term of the loan. In March it was 2.25% for a short-term loan, 2.97% for a midterm loan, and 4.27% for a long-term loan. At those rates the tax consequences are minimal.

For example, a parent can make a $200,000 loan to a child for five years and charge the short-term rate. The child invests the money and keeps all returns above the short-term rate. After five years the principal plus short-term interest are returned to the parent. There are no gift or estate taxes on the income the child keeps, and that wealth is out of the estate.

I wrote about low interest loans in the January 2002 issue. The article is available in the Grandkids’ Watch section of the Archive on the subscribers’ web site.

For any of these strategies it is important not to give away assets that are needed to maintain the desired lifestyle. If an estate will be taxable, however, and there are assets above that level, now is a good time to transfer some of the assets out of the estate.

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