Planning Opportunities During Market Declines

While market volatility provides investment opportunities, it can also provide tax planning and gifting opportunities. Roth conversions and intra-family gifting are examples of strategies to consider when asset prices are depressed.

Roth Conversions

If you were in the lowest tax brackets in 2021 or expect to be in the lowest tax brackets in 2022, you may have a great opportunity to convert traditional IRA assets to a Roth IRA and owe minimal tax. In general, the purpose of the conversion is to “convert” pre-taxed assets into post-tax assets at favorable tax rates. Conversions are primarily a tax decision and secondarily an investment decision, so it is important that you seek help to project the tax consequences of potential conversions and to determine the strategy for reallocating the converted assets.

Marketable securities can be converted “in kind” to avoid the need for liquidating shares. For example, if “XYZ” stock has fallen from $20/share to $10/share, it may be more efficient to convert shares of “XYZ” stock instead of selling the shares in the traditional IRA, converting the cash, and then repurchasing the shares within the Roth IRA. In the ideal situation, the shares would recover within the Roth IRA and the gains would avoid future federal and state taxation. For more details on the strategy, please review the article Don’t Waste a Low Tax Bracket.

Intra-Family Gifting

The annual gift exclusion is now $16,000 (up from $15,000 in 2021). This is the maximum amount an individual can gift to another individual while avoiding the need to file a gift tax return. To clarify, an individual can give $16,000 to separate individuals in the same calendar year, but each individual gift must not exceed $16,000 if the giver would like to avoid filing a gift tax return. For example, Jim can give his two daughters, his nephew, his neighbor, and his best friend $16,000 each and avoid the need to file a gift tax return; however, if he gives any one of them $16,001, the IRS expects him to file a gift tax return to report the $1 of reportable gifting.

Gifting highly appreciated assets that are temporarily depressed is a good strategy for satisfying your 2022 intra-family gifting goals. For example, Jim has historically given Sarah (his adult daughter) $15,000 per year in annual cash gifts to accomplish his gifting and estate reduction goals. An alternative is to gift $16,000 (the new limit) of marketable securities from his trust account. Assuming his cost basis is $5,000 in “XYZ” stock and the current market value is $16,000 (down from $20,000), let’s see how this compares to giving cash.

Cash Gift

Cost to Jim: $16,000 (no gift tax or income tax implications)

Jim’s Estate Reduction: $16,000

Gift of “XYZ” Stock

Cost to Jim: $16,000 (no gift tax implications)

Tax Basis of Gift: $5,000 ($5,000 will be Sarah’s cost basis; the same as Jim’s)

Jim’s Estate Reduction: $16,000+ (if Sarah holds the shares and they recover to $20,000+, the effective gift and estate reduction can greatly exceed $16,000. If the position provides a dividend, this income will be shifted to Sarah, which will lower Jim’s taxable income).

Once Sarah has the shares, she can hold or sell them. If she sells them for $16,000, she will realize a long-term capital gain of $9,000. The tax implications of selling gifted stock are generally straightforward, but there are exceptions. Charles Schwab’s “How Do You Value a Gift of Stock…” is a good first read on the subject.

If Sarah is in the lowest tax brackets, she may owe little to no federal tax. According to the IRS, “The tax rate on most net capital gain is no higher than 15% for most individuals. Some or all net capital gain may be taxed at 0% if your taxable income is less than or equal to $40,400 for single or $80,800 for married filing jointly or qualifying widow(er).

A capital gain rate of 15% applies if your taxable income is more than $40,400 but less than or equal to $445,850 for single; more than $80,800 but less than or equal to $501,600 for married filing jointly or qualifying widow(er); more than $54,100 but less than or equal to $473,750 for head of household or more than $40,400 but less than or equal to $250,800 for married filing separately.” (Source)

Tax and gift planning are important parts of your overall plan. As always, we recommend consulting your tax adviser and reviewing the tax implications thoroughly before acting.