Strategist: Volatility can be your friend

  • Times of volatility may spook investors, but a downturn in the market can be used as a tax-efficient friend from a long-term estate planning perspective.
  • The 2017 Tax Cuts and Jobs Act nearly doubled the estate, gift, and generation-skipping transfer tax (GST) exemption, and investors can use strategies to "lock in" gains now.

There is no question that the financial market landscape has been challenging, particularly at the end of 2018.

Volatility has moved up from 2017's exceptionally low levels, investor sentiment is fragile, and some are questioning whether the U.S. is heading into recession.

However, volatility may not be the enemy, but a very tax-efficient friend, from a long-term estate planning perspective.

The 2017 Tax Cuts and Jobs Act nearly doubled the estate, gift, and generation-skipping transfer tax (GST) exemption, which is $11.4M per person in 2019 and $22.8M per married couple. Without further Congressional action, the exemption will revert back to pre-tax reform levels in 2026, approximately $5.5M per person. Given how quickly things can change in Washington, it is possible that new legislation could reduce the exemption even before the current law expires, perhaps if a Democrat wins the White House in the next election.

Janhvi Bhojwani | CNBC

Increased exemption amounts — even if temporary — create an opportunity to use strategies to "lock in" the exemptions and minimize future transfer taxes, even if the higher exemptions expire at some later date. So it's important for taxpayers to take advantage of the increased exemption sooner rather than later by exploring some tax-efficient, long-term estate planning strategies.

There are a variety of ways to maximize this lifetime gifting opportunity to benefit heirs for generations to come – particularly when there's a downturn in the markets. One option is to create a long-term dynasty trust, which is created to pass wealth from generation to generation without incurring transfer taxes. It is possible to set up this trust and gift a portfolio of assets up to the $11.4M exemption amount, without incurring any gift tax (currently at a federal tax rate of 40%). Any future gains/growth from the trust would be free from estate, gift, and GST tax.

By waiting until the market is in a downward swing and gifting the assets into the dynasty trust when the assets have a lower valuation, one can maximize the appreciation potential of the trust—again without incurring any gift tax.

Let's look at an example:

An investor owns shares in a hypothetical stock ALVINA with the current lifetime gift exemption amount of $11.4M equal to approximately 11,000 shares of the stock (at today's price of $1036/share). If the market were to drop 20%, and the share price dropped 20% to $829/share, that $11.4M is now equal to 13,750 shares. That gives the investor 2,750 more shares (25%) gifted to the trust—gift tax free.

Alternatively, if the investor only wanted to gift 11,000 shares of the stock, with a downward market turn of 20% the value of the gift would be $9,120,000 (11,000 shares x $829/share). Therefore, the gift to the trust would only use up $9,120,000 of the lifetime exemption. This leaves another $2,280,000 ($11,400,000 - $9,120,000) of the exemption available for future use.

It's important to remember that valuation is key when it comes to gifting and estate planning, and there are a number of strategies that are even more effective if you catch the market right. You can turn volatility into a friend if you're long on the market for estate planning. Many say "buy low/sell high" but I say—gift low, preserve high.

Alvina H. Lo is Chief Wealth Strategist at Wilmington Trust.