Bessemer Trust - A Closer Look to Integrated Wealth Planning

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1 June 2015 A Closer Look Counterintuitive Approaches to Integrated Wealth Planning Bessemer Trust s mission is to design strategies that help our clients achieve personal and financial goals. To do so, we navigate headwinds such as market volatility and changing tax laws. Sometimes, the solutions for these challenges are not straightforward and contradict conventional financial advice. For example, sometimes our clients are surprised to hear us suggest that they should: Peter J. Langas Chief Portfolio Strategist Not use their lifetime estate-tax exemptions; Invest in a volatile, concentrated portfolio; Keep more money by giving it away; and Pay taxes now and not later. Counterintuitive approaches may benefit clients when we integrate tax, estate, and investment planning. In this A Closer Look, we highlight customized solutions that, when implemented, may help clients grow and enhance their wealth. Federal Tax Changes Prompt New Approaches to Tax Optimization Stephen A. Baxley Director of Tax & Financial Planning Lynn Halpern Lederman Senior Fiduciary Counsel Northeast Region Tax consequences are material considerations in developing a long-term wealth management plan. Many investors know that taxes on most categories of investment earnings increased in They may not, however, realize that recent tax-related changes may benefit taxpayers who are willing to consider unconventional strategies. The Taxpayer Relief Act introduced two primary changes to the tax code. First, the Act increased the top rate for long-term capital gains and qualified dividends from 15% to 20% and imposed a 4.6% tax increase on ordinary income. Second, we saw the return of the Pease provision, commonly known as the stealth tax. For certain higher-income taxpayers, the Pease provision imposed a marginal 1.2% income tax rate increase. Additionally, the Patient Affordable Care Act imposed a 3.8% new net investment income tax on higher income taxpayers. The cumulative effect of these new taxes was significant. Overall, we saw a 27% increase in the top rate on ordinary investment income and a 67% increase in the top rate against long-term capital gains and qualified dividends. These significant changes required us to reconsider our traditional advice. We ll share more, here, about integrated strategies that tilt toward the unconventional. Tax Convergence Shifts Estate Planning Technique While income tax and investment tax rates have increased, we have watched federal gift and estate taxes move lower. For example, in 2001, U.S. federal tax code allowed an individual a tax-free wealth transfer of $675,000 during life or at death. In 2015, the basic exclusion threshold is

2 $5.43 million for a single individual a number that will be indexed against future inflation. In addition, federal estate and gift tax rates decreased from 55% to 40% over the past fourteen years. This tax convergence has caused us to reevaluate the advice we may give to clients. In the past, the disparity between income and transfer tax rates made giving during one s lifetime the rational strategy to minimize a tax burden. However, as transfer taxes are no longer so much higher than income taxes, the choice is not as clear. This convergence requires us to adapt our planning recommendations and some of these recommendations are counterintuitive. Integrating Potential Investment Outcomes into a Wealth Plan As noted, we believe in the value of integrating tax, estate, and investment strategies to develop a comprehensive wealth management plan. This inte gration requires us to consider many factors. For example, the tax environment has changed consid erably. In 2001, we would have advised a client with a low-basis, concentrated asset to gift or transfer the asset during life. However, in this new world of higher income and lower transfer taxes, the decision to transfer the asset during life is not so straightforward. While we want to minimize our clients taxes, we must also consider potential investment downside risks. For an owner with a concentrated position in a lowbasis asset, an integrated ap proach requires us to ask whether anyone who holds the stock should sell it now or later. And with this question, we introduce the possibility of a counterintuitive answer that allows the owner to divest the asset, retain a cash flow, and direct a gift to charity. The type of asset owned, its growth potential, and whether the gift recipient would seek to sell the asset will influence whether to gift the asset during life or transfer as part of an estate. (Sometimes) It s Better Not to Use Your Lifetime Exemption In the past, conventional estate planning bias encour aged asset transfer during life. Since 2001, the planning landscape has changed and may call for a coun ter intuitive solution such as not using the life time exemption. Consider a scenario in which a $1 million cost-basis individual stock holding has appreciated to a fair market value of $10 million: If the owner gifts the asset outright, the recipient will likely incur a substantial tax liability on the $9 million capital gain; If the owner retains the individual holding until death, the asset value immediately steps up to $10 million; The stepped-up value would not incur capitalgains tax liability at liquidation. However, estate taxes would be applicable against the stepped-up asset s value; and In 2015, under these facts, the decision to transfer in life or as part of the estate has nearly identical tax consequences (Exhibit 1). Exhibit 1: Give Now or at Death? The Math Is Different Today We ll consider this approach in this look at integrated solutions that help optimize wealth management planning. Gift/Sale Bequest/Sale Gift/Sale Bequest/Sale Gift Tax Income Tax Estate Tax Balance to Child Source: Bessemer Trust analysis 2

3 This example demonstrates the similar tax conse quences of gifting an asset in life or transferring as part of an estate. However, from an investment perspective, there are potential downside risks to holding a concentrated position. So, the question also becomes whether anyone who owns the stock should sell in the present or in the future. (Sometimes) You re Better Off Investing in a Volatile, Concentrated Asset Conventional financial planning advice typically suggests diversifying away from holding a concentrated, volatile asset. However, in some circumstances, a client may improve outcomes by holding a con centrated asset through a frequently used estate planning strategy known as a Grantor Retained Annuity Trust ( GRAT ). In a GRAT structure, the person (grantor) who establishes the irrevocable trust owns the vehicle and is responsible for any income taxes. The GRAT is a wealthtransfer vehicle designed to pass appreciation to subsequent generations to reduce a grantor s taxable estate. Typically, an individual who wants to minimize estate taxes funds a GRAT s initial balance for a two- to three-year time period. The shorter-term structure allows the GRAT to benefit from volatility and augments the likelihood that the grantor will outlive the GRAT s term. A GRAT is analogous to a loan that requires an interest payment on the loan principal. Because a GRAT is typically structured to pay the IRS-mandated interest and principal back to the grantor, the IRS does not view the transaction as a transfer-taxable event. If the trust assets achieve a 7% return, the trust will hold an $811,000 balance for the child. If the trust assets achieve a 12% return, the beneficiary enjoys a substantially greater economic benefit of $1.67 million as a tax-free transfer (Exhibit 2). Exhibit 2: How Does a GRAT Work?* * Assumes the 1.8% interest rate required by the IRS in May Clearly, the investment return is of paramount importance in determining the success of a GRAT. Usually, we advocate building a diversified portfolio to reduce volatility and enhance risk-adjusted returns over time. With a GRAT, however, we want volatility. Investing in concentrated, more volatile assets may provide a better chance of passing more on to the next generation (Exhibit 3). Exhibit 3: Sometimes You re Better Off Investing in a Volatile, Concentrated Asset Asset Growth $10 million Year 1 = $4.7 million Year 2 = $5.6 million Diversified Portfolio Volatile Asset Growth Threshold Re-GRAT For illustrative purposes only. GRAT Funds Are Invested Trust for Children 7% Return = $811,000 12% Return = $1.67 million Lock-in Success Surplus New Growth Threshold Year 1 Year 2 Year 3 Surplus While volatile asset classes may react more negatively to a market downturn than a diversified portfolio, these classes also potentially recover 3

4 more quickly and generate stronger returns. In a downturn, the power of volatility may be harnessed by swapping assets into a new GRAT and resetting the clock. Re-GRATing the assets provides the opportunity to reap a larger benefit as a volatile asset class is likely to rebound more strongly. In the end, a diversified portfolio may be successful for GRATs. But harnessing the volatility of concentrated strategies may provide an even more powerful wealth-transfer vehicle. In the volatile markets of 2008, Bessemer Trust helped many clients benefit from this structure and strategy, particularly those with concentrated assets. (Sometimes) The Best Way to Keep More Money Is to Give It Away To some of our clients, it may seem counterintuitive when we suggest that they may benefit more from their assets by giving them away. However, the gifting suggestion can yield positive results if an asset owner has a substantial holding in a low-basis stock. For example, consider the case of California residents with a concentrated position in a low-basis stock. The stock basis is $400,000 but is fair-market valued at $12 million. The family has determined that for investment reasons, it needs to diversify the holding and create cash flow. The family is also charitably inclined and would like to give in a tax-efficient manner. In this case, a Charitable Remainder Trust ( CRT ) allows the family to reap more from the asset by giving it away. In the case of the California family, a CRT eliminates the downside risk of a concentrated position. A CRT also harnesses the power of deferral. This counterintuitive approach avoids a large tax liability upfront and enables more assets to be invested for growth and to provide a payout stream. (Sometimes) It s Better to Pay Taxes Now and Not Wait Until Later The foundation of many tax strategies is to find tax deferrals. However, in some situations, the unconventional strategy to pay taxes earlier, rather than later, is a better one. Consider a situation in which a client has a large IRA with assets that will not be needed to fund retirement. The beneficiary of the IRA may be an adult child who has experienced difficulty managing finances or is not adept at budgeting or investing. A client with a goal of providing a dependable lifetime stream of income for the child may wish to consider a Roth IRA conversion. By converting from a regular to a Roth IRA, the owner will incur income tax on the transferred amount. However, the conversion will create a In a Charitable Remainder Trust (CRT), the asset owner transfers assets to a trust. In exchange, the original asset holder receives a fixed percentage of the asset s value each year over the term of the trust. Upon CRT termination, the residual assets pass to the designated charitable cause. The CRT structure provides a number of benefits: The asset owner will be eligible for an upfront charitable tax deduction against the present value of the future gift; The CRT may liquidate the asset and diversify without incurring current capital-gains taxes. The owner pays capital gains and income taxes on the CRT payments; and A CRT spreads income tax liability over the term of the trust. 4

5 goose that lays the golden egg. The assets in the Roth IRA will benefit from long-term, tax-free growth and future tax-free distributions. In some cases, the owner may structure the Roth IRA to pay distributions through a conduit trust over a term to match the beneficiary s expected lifetime. Moreover, the trustee has discretion and is not mandated to withdraw any amount more than the required minimum to enable long-term, taxfree growth. Although there is an upfront tax cost, strategies exist to minimize the tax impacts to reap the longer-term benefits of a Roth IRA conversion. Putting It All Together Counterintuitive Takeaways No wealth management decision should occur in a vacuum. Bessemer Trust monitors the changing tax, estate, and investment landscapes to help our clients achieve their wealth planning objectives. Part of this vigilance requires that we reconsider conven tionally accepted recommendations and practices to offer customized, sometimes counterintuitive, solutions. Our multi-faceted, integrated approach is a hallmark of our client service offering and how we help families achieve financial goals. This material is for your general information. It does not take into account the particular investment objectives, financial situation, or needs of individual clients. This material is based upon information obtained from various sources that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in economic growth, corporate profitability, geopolitical conditions, and inflation. The mention of a particular security or asset class is not intended to represent a specific recommendation, and our views may change at any time based on price movements, new research conclusions, or changes in risk preference. Atlanta Boston Chicago Dallas Denver Grand Cayman Greenwich Houston London Los Angeles Miami Naples New York Palm Beach San Francisco Seattle Washington, D.C. Wilmington Woodbridge Visit us at Copyright 2015 Bessemer Trust Company, N.A. All rights reserved.