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WHEN MARKETS—AND INTEREST RATES—TUMBLED this spring as a result of the pandemic, many investors focused immediately on their portfolios.
But reviewing and rebalancing your portfolio isn’t the only action you might consider taking now. Volatility and low rates can provide opportunities for more tax-efficient giving, saving for retirement and meeting other important financial goals, says Mitchell Drossman, national director of wealth planning strategies for Bank of America’s Chief Investment Office. After all, “when markets rebound, you want the value of your assets to rise in the most tax-efficient way and in the most efficient location,” he adds.
Below, Drossman and Kevin Hindman, managing director, Retirement & Personal Wealth Solutions at Bank of America, highlight five strategies that can potentially minimize taxes in volatile, low-rate environments. Discuss them with your tax professional and financial advisor to see whether they might make sense for you.
"When markets rebound, you want the value of your assets to rise in the most tax-efficient way and in the most efficient location."
Consider a Roth conversion. Now could be a favorable time to move some assets out of a traditional IRA into a Roth IRA, Drossman notes. Though the assets are generally subject to federal (and generally state) income tax when you convert from a traditional to a Roth IRA, because the value of the assets may have dropped, “the amount of income to be recognized may be lower.” This may not only mean lower taxes but it may also keep you in a lower tax bracket. It’s also worth noting that required minimum distributions from most retirement accounts have been waived for 2020, which may also put you in a lower tax bracket this year.
Once inside the Roth IRA, the value of the assets may not only rebound but also grow in a tax-free environment—and you won’t have to pay federal (and generally state) income taxes on any qualified distributions you might take.1 If you believe tax rates may rise in the wake of massive government stimulus spending during the pandemic, paying taxes now rather than later could also save you money, Drossman adds.
Harvest investment losses. Strategically selling assets at a loss can help offset capital gains taxes when you sell other assets in your portfolio that have appreciated, a strategy known as tax-loss harvesting. Keep in mind that you can harvest the losses now and wait for the right moment to use them. Additionally, taxpayers may be able to deduct up to $3,000 of capital losses per taxable year against ordinary income. “Capital losses, whether short- or long-term, can be carried over indefinitely,” Drossman says.
Boost your giving to beneficiaries. Because taxes are based on a gift’s fair-market value at the time it is made, temporarily depreciated assets may offer an opportunity to give more shares, whether directly to an individual or through a trust. For instance, under the current annual gift tax exclusion ($15,000 per recipient), “if you have 1,000 shares that were worth $15 ($15,000) and they drop to $7.50 per share ($7,500), you could now give away twice as many shares with no gift tax implications and let the recipient wait for the assets to recover,” says Hindman.
Set up a grantor-retained annuity trust. Grantor-retained annuity trusts (GRATs), a popular technique for making tax-efficient gifts to beneficiaries, are especially attractive when interest rates are low. That’s because the IRS assumes the growth rate of assets placed in a GRAT will equal current Treasury interest rates. Any appreciation beyond that rate passes to beneficiaries gift-tax-free. Today, the assumed growth rate, or “hurdle rate,” for GRATs is an all-time low of 0.6%—meaning even a moderate return can result in a successful tax-free gift.
A charitable lead annuity trust (CLAT) operates in much the same way, except in this case the annual payments go to a charity. When the trust terminates, any remaining assets go to the non-charitable beneficiaries. “CLATs are a great way to support charitable causes you care about and potentially transfer wealth to beneficiaries without any gift tax,” Hindman says.
Make a family loan. If you’re looking to help a loved one with a loan, now may be a particularly good time. To avoid gift-tax issues, any lender (even a parent loaning money to a child) must charge a minimum interest rate established by the IRS, Hindman says, and that rate can be as low as 0.18% for loans made in June 2020.
Some families use loans as a tax-efficient way to transfer wealth: Instead of purchasing real estate or investment assets yourself, you might consider lending money to a family member, who makes the purchase. The assets can appreciate outside of your estate, and the family member may be able to use asset income to repay the loan.
1 For a distribution from a Roth IRA to be federal (and generally state) income tax-free, it must be qualified. A qualified distribution from a Roth IRA is one that is taken at least five tax years after the first day of the year of your first Roth IRA contribution or Roth conversion and you (i) are age 59½ or older; (ii) are disabled; (iii) qualify for a special purpose distribution such as the purchase of a first home (lifetime limit of $10,000); or (iv) are deceased. If you take a nonqualified distribution, any Roth IRA investment returns are subject to regular income taxes, plus a possible 10% additional federal tax if withdrawn before age 59½, unless an exception applies. A special provision applies for converted assets. If a nonqualified distribution is made within five years of the conversion, the earnings withdrawn will be subject to income tax, and the entire withdrawal may be subject to an additional 10% federal tax unless an exception applies.
Information is as of 07/09/2020
Investing involves risk including possible loss of principal.
Opinions are those of the author(s), as of the date of this document and are subject to change.
Past performance is no guarantee of future results.
The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for Global Wealth & Investment Management ("GWIM") clients, is part of the Investment Solutions Group (“ISG”) of GWIM, a division of Bank of America Corporation (“BofA Corp.”).
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.