Wisdom in Wealth

Strategies, Stories, and Lessons Learned Over the Course of 25 Years Helping Families Plan Their Financial Lives

4 Planning Opportunities in Cyclical Volatility

By William Beynon & John Walker | July 22, 2022

AdobeStock_472128786-jpegLet’s be honest, this cycle has been a rough one for many. We remember other ugly times like the tech wreck in the early part of the century, and the subprime crisis between October of 2007 and March of 2009. In between, we have lived in one of history’s best growth periods. Obviously, nothing is perfect, and all portfolios experience the markets based on entry points, trading, and taxation, but one down year since 2009 is a great outcome. Many of the families we steward appreciate that, but humans are wired to feel a crushing loss far more intensely than a massive win. Our view is that cycles typically usher in a new / different set of leaders. Before we get to the points we are about to make, we want to remind you that markets are positive far more than they are negative from a calendar perspective. Even though these moments feel like forever as we live them, we can take certain advantage of a failing cycle. I want to point to four of the innumerable options here. First is tax loss harvesting, second is Roth IRA conversion, third is gifting to family outright and fourth by use of grantor retained annuity trusts.

     1. Tax-Loss Harvesting

When you purchase a capital asset (stocks, bonds, ETFs etc.) with non-qualified money that was already taxed as income, you are making a tacit deal with the IRS. If you choose your investments well and sell for a profit, the IRS will be able to collect a capital gains tax. These days that tax can range from zero to twenty percent of the gain. If you dispose of the asset for a price below what you paid, you have two options. You can use three thousand dollars’ worth of that loss as deduction from active earned income, or you can potentially use it as offset for a future capital gain. The American income tax system works in a graduated debits and credits system. So, by moving on to better ideas and selling ones that didn’t play out how you hoped you can build up this credit against future losses. The hope here is that by selling things that didn’t work how you planned, you can store losses for what we all hope is a very prosperous growth cycle to follow this sour loss cycle. These carry forward capital losses can be tracked and used to offset future gains. In professional settings, Capital Wealth Advisors uses this technique in many of our households. We look for similar businesses in the same sector of those we own that we can exchange while they are both undervalued. By selling our holding and exchanging it for a competitor, we can capture a valuable carry forward loss while still retaining the overall portfolio’s risk and sector weights. The use of similar businesses prevents violation of the disallowed loss rules (wash sales) the IRS imposes. The main idea of these trades is to capture a badly needed tax benefit from the rebalancing work that we should all be doing.

      2. Roth IRA Conversion

Next up is Roth IRA conversion. It is my opinion that a negative market can present a valuable opportunity for Roth conversion. First let’s define the mechanics of conversion, and next let’s discuss the pros and cons of doing so. We think of the Traditional IRA and Roth IRAs as different sides of the same concept. Let’s use seeds and crops as an example. When the traditional IRA is used properly, we get a tax deduction for the contribution. The “seed” in this analogy. Then once we retire or become retired (RMD), we take distributions the “crops” from the account. Hopefully, the tax-deductible seeds grew into a great crop, and we pay income tax on whatever dollar amounts get removed. The IRS doesn’t distinguish between gain or loss dollars as they come out of traditional IRAs. It is taxed as all normal income. It doesn’t take a fancy calculator to see that the deferral of capital gains, dividend and interest income taxes can be wildly beneficial for the growth of the investments, which is why this is such a popular arrangement. Now, let’s examine the opposite mechanic in the Roth IRA. Here, we are taxed on the “seed” contribution, but we get the “crop” income tax and required minimum distribution free. From a tax perspective, the money that leaves the Roth IRA has no gain or loss tax character but is tax free at distribution. Moving on to the mechanics of the conversion, you could describe the Roth conversion as taking IRA money which hasn’t been taxed yet and pouring into an account which may never be taxed at all. Sadly, the reality is that the IRS will want taxes somewhere along the way. In the case of the Roth conversion, taxes are owed in the year of the conversion.

So, why should I consider paying tax on a Roth conversion while my portfolio is suffering?

The real key here is converting the assets in share form. Let’s say you bought a stock for $100 and, now is currently down 15%. The valuation of the stock during conversion is $85, not $100. You would only pay income tax on the $85 in the year of the conversion instead of the $100 acquisition value. Here is where a little faith is required. If you believe as we do that the markets will recover at some point and your stock will recover its value and maybe go higher, this transaction starts to make a lot of sense. To recover from a 15% loss, a subsequent 17.65% gain is required. In 37 years since 1927, the US stock market has had enough upward movement to cover that loss in one single year. Obviously, the more loss a stock suffers, the more growth required to get back to break even. Additionally, we are living in a time of historically low income and investment taxation. If income taxes go up with the markets, that breakeven point may be even further away. As we have stated previously, markets are not down this far very often so there is certainly a “carpe diem” effect at play given all the opposing forces at work in Washington.

     3. Gifts

The third point I want to highlight is about gifting stock that isn’t at a net loss but may have receded in value somewhat. The government allows us an annual gift in 2022 of $16,000¹ in money or money’s worth. We do not normally suggest gifting stock below the initial basis because you could sell, collect the forward loss, and give the cash to the beneficiary. However, if you have a stock that is above basis but is a down from a high point, you might gift it directly to a donee. As with the Roth IRA conversion, a belief that the stock will recover its value sometime soon is handy. The process is fairly simple. You give the gift; they receive it and hopefully before too long it has grown to maybe an even higher value than when you gifted it. All the reflation of the gifted stock occurs in the estate of the donee. Thus, you have decreased the size of your estate, given a gift that is totally lawful, and boosted it by giving it in kind and allowing its notional value to recover and continue growing. This process requires no additional tax work if the value of the securities is below the annual exclusion gift limits ($16,000 in 2022).

What if I wanted to give a gift larger than the annual exclusion?

There are several factors at work here, the size of the gift, the age of the donee, and the intent of the gift to name a few. If any of the following sound like something you are considering, please reach out to us, and seek the support of tax and or legal professionals as needed. Starting with the simplest version of the story, all that is required to give a larger than exclusion allowance is the filing of IRS 709. This is the form used to pre-allocate some of your federal lifetime gift credit. Far too few know that you are legally able to give large gifts over your lifetime. The IRS simply asks to be told that you are doing so. The 709 is the way to do so. In fact, using this method to gift to people 37.5 years younger or more (two lineal generations) than you is particularly valuable. IRS guidelines imply that they feel entitled to a tax at every lineal generation, so if you gifted to your grandchildren as an example in lieu of your children, the IRS may feel slighted by the “skip”. So, by using your credit this way you could possibly save on more than one type of tax.

     4. Grantor Retained Annuity Trust (GRAT)

In this vein, we arrive at the final and certainly most complex method gifting, and that is the Grantor Retained Annuity Trust (GRAT). We feel it is important to say that these are complex vehicles and the words that follow will be an accurate albeit simple version of a fairly complex planning machine. The main idea here is that a person can create a special entity and gift into it in such a way that the gift will be given back to them over time (often 2 to 10 years). If the assets given to the entity grow faster than the current Section 7520 Federal mid-term rate (3.59% as of July 2022)² over the course of re-gifting, the coverage is left in the trust and is passed to beneficiaries totally estate tax free. The real value in this is to put a rapidly growing asset into this arrangement so that the appreciation is removed from the estate of the donor and shifted to estate of the donee. If the gift is given at a low point in the life of the asset and it recovers beyond the value on the date of the gift, it can be “zeroed” out for the donor, and they are freed up to do further gifting. If that rapid growth fails to occur, the gift is still returned to donor with no further consequence. So, in today’s tough economy, it may be worth a look to give depreciating albeit high expectation stocks through this method. It bears repeating that this is a complex structure and has many more facets than were described here. Please partner with the appropriate tax, legal, and investing professionals.

In summary, no families are the same. Your family might benefit from all or none of these strategies. The goal of this writing is to cause you to review your portfolio with a keen eye toward making something many regard to be totally negative into something that can benefit you. Finding the silver lining in an otherwise stormy grey time. As always, we would be happy to evaluate your family dynamics and partner with you in finding the most appropriate ways to benefit from a tumultuous time. In times of market volatility, it is also prudent to evaluate your risk tolerance and allocation.

Image Source: Adobe Stock
¹ What's new - estate and Gift Tax. Internal Revenue Service. (n.d.). Retrieved July 20, 2022, from https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax
² Section 7520 interest rates. Internal Revenue Service. (n.d.). Retrieved July 20, 2022, from https://www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates 
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William Beynon
President & CEO

Co-Author of Wisdom in Wealth.

John Walker
Executive Vice President | Private Wealth Management

Co-Author of Wisdom in Wealth. 

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