Estate Planning in a Down Market

Today's low valuations and interest rates make this a good time to make gifts to your heirs

By Amy Feldman

When times are tough, people tend to hold on to what they have that much more tightly. But for those who can get beyond that psychological response, there's a silver lining in today's combination of depressed asset values and low interest rates: Transferring assets to the next generation has rarely been less costly.

That's because depressed valuations allow you to get those assets out of your estate and over to your kids with less gift tax, while low interest rates create additional advantages for those who use certain wealth-transfer vehicles or intra-family loans. In fact, with the Federal Reserve cutting interest rates, the rates set by the Internal Revenue Service for use in one of the most popular wealth-transfer vehicles, known as a grantor retained annuity trust, or GRAT, is now at an historic low of 2.4%, down from 3.4% in December. The rates for intra-family loans are at similar historic lows, now just 0.81% for a short-term loan.

"If the markets are going to recover, then let that recovery be on your kids' balance sheet rather than yours," says Don Weigandt, a wealth adviser at J.P. Morgan Private Bank (JPM) in Los Angeles. "The major issue is psychological. It's the brain battling the heart."

BASIC GIFTING TECHNIQUES

Wealth transfer is a huge issue for those who expect their heirs will have to pay estate taxes at rates up to 45%. The tax code permits $3.5 million to be exempted from estate taxes, $1 million of which may be given away before death as gifts. The estate tax is in play in Washington now. Under current rules, it disappears briefly in 2010, then returns with a lower exemption and a higher rate in 2011. But experts believe Congress will take action before the tax disappears and that the $3.5 million exemption is likely to remain.

For 2009 you can give away up to $13,000 per beneficiary without having to pay taxes. (The $1 million lifetime limit applies to gifts above that yearly gift exclusion.) When asset values are depressed, as they are now, that gift-tax exclusion is more valuable. Consider: If you have 500 shares of Stock A that traded at 100, with the gift-tax exclusion at $13,000, you would have been able to transfer only 130 shares before bumping up against the hefty tax. But if the shares have been knocked down by 40%, in line with the broader market, you can transfer 217 shares tax-free. The same thinking applies to getting the most out of the $1 million exemption. (The downside risk: If the stock keeps falling, you've used up part of your exemption for nothing.)

This is the simplest of all estate-planning moves for a down market. "You're trying to reduce the size of your balance sheet before you die," Weigandt says. "The question is, are you comfortable reducing your current assets to save your kids something on the estate tax? That question is harder now. But it's not all or nothing: You could take steps to give away heavily discounted assets in smaller increments."

A NO-LOSE TRUST

A GRAT is an irrevocable trust designed to transfer the appreciation on assets contributed to it with minimal or no gift-tax consequences. It's a popular strategy for transferring wealth in a low-rate environment. That's because of the current IRS-mandated interest rate of 2.4%. Here how it works: Let's say you set up a GRAT and fund it with $1 million in badly depressed stock. Assuming the simplest scenario and a trust term of two years (it could be longer), the GRAT would make annuity payments to you valued at $518,081 in each of those two years. (That includes a calculation of present value you don't want to do at home; those payments can be made in cash or stock.) If the asset appreciates more than those payments—and the odds of that seem good, with a low "hurdle" rate of 2.4%—the excess goes to your beneficiaries tax-free.

If it turns out the asset has appreciated less than those $518,081 payments, the trust fails. The asset returns to you, and you can start another GRAT and try again.