Estate Planning in a Down Market

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

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."


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 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.

A rolling GRAT strategy allows multiple possibilities of catching the asset's rise at a valuable moment. GRATs have a standard structure, so setting up the second or third one is less expensive than the first. (A simple GRAT might cost about $5,000.)

"There is no downside to doing a GRAT," says Sharon Nelson, a trusts-and-estates attorney at Foley & Lardner in Chicago. "If the assets appreciate at a higher rate than the IRS's hurdle rate, the beneficiaries win. If it fails, you don't lose anything. You didn't use up gift tax doing something that didn't work."

For those who keep rolling assets from one GRAT to another, today's market swings, the bane of investors, are positive. "Volatility in the market is a wonderful thing in GRATs," says Michael Gooen, chairman of trusts and estates at law firm Lowenstein Sandler in Roseland, N.J. "You constantly have these cascading GRATs. Because you lose nothing from guessing wrong and stand to gain a lot from guessing right, you want to guess as many times as you can."

The best assets to put in a GRAT are liquid (since the trust needs to make those payments to you) and focused within one asset or industry—say, one stock or stocks within the same industry. "A financial adviser will say to a client, `Make sure you are diversified.' In a GRAT, it's the reverse," Nelson says. "While you want your overall portfolio to be balanced, your GRAT should be very concentrated." That's because if you have three stocks in a GRAT and two go up and one goes down, the trust might fail overall. But if you have three GRATS, each with a single stock, the one that goes up will succeed regardless of how the other two perform.

Who should use GRATs? Those who think there's a good chance they'll have accumulated more than $3.5 million by the end of their lives. As with other estate-planning techniques, the best time to be considering this is when you're in your 50s. That's because you can expect more appreciation over the long term and because if you die before the GRAT's term ends, the assets in it become part of your estate.

Another good strategy in these low-rate times is to lend money to your kids on the cheap. For short-term loans—up to three years—the IRS's rate for intra-family lending is now just 0.81%, and the loans can be structured as interest-only, with a balloon payment at the end of the term. (There are somewhat higher rates for medium- and long-term loans.) Those rates are at historic lows. While the likely main reason to do this is personal (helping an adult child buy a house at terms better than any bank would offer, for example), it has benefits for estate planning. If your kids earn more than the IRS's rate on the funds you've lent them, they keep those gains tax-free. "There are clients who are otherwise reluctant to give gifts," says Lowenstein Sandler's Gooen. "They want to save gift exemptions or have already used them. For those folks, the concept of a loan works great with rates as low as they are."

    Before it's here, it's on the Bloomberg Terminal.