By Mallon FitzPatrick
October 31, 2022 – There is little any individual can do about 2022’s market volatility or high inflation, escalating geopolitical conflicts, and rising interest rates adding fuel to the fire. However, you can strive to improve your long-term wealth plan’s prognosis by taking full stock of the current environment and what it means for you in the long-term.
With 2023 right around the corner, now’s as good a time as any to start. This is the season for end-of-year planning, the annual practice where you sit down with your team to assess how your circumstances changed over the year and determine whether you are still on track to meet your planning objectives.
In the interest of fortifying plans against external forces, we periodically make changes to account for identified threats and take advantage of opportunities trigged by regulatory shifts, modified tax policies, and adverse market performance. These continual adjustments streamline the end-of-year planning process and allow for gradual, steady changes to be made to one’s plan and portfolio rather than sweeping, sudden alterations.
This is also the time to alert your wealth manager of any major life events that have taken place. This includes, but is not limited to, marriage, divorce, the arrival of a newborn, a death in the family, a job change, a name change, a decline in health, a recent or potential windfall from an inheritance, a business sale, or a liquidity event.
Don’t Forget Your Annual Gifting, Donations, and RMD
There are several particulars to consider when navigating gifts and deductions. 529 plan contributions, otherwise known as the “Roth for education,” may be state tax-deductible depending on location. Likewise, be deliberate about gifting cash or assets up to the annual exclusion amount — $16,000 for single filers and $32,000 for married filing jointly taxpayers —either directly or to trust via Crummey Letter.
Charitable donations will likely allow for deductions and will reduce your taxable income for 2022. We recommend donating securities with significant appreciation and avoid realizing gains. Consider donating these securities to a Donor Advised Fund (DAF). The DAF is like having a Private Family Foundation without the complexities. Be aware that because markets are down and your position value likely is too, you won’t get as much of a deduction as you would in more robust economic circumstances.
Confirm that you have taken your Required Minimum Distributions (RMD) from your retirement accounts; penalties are high for non-compliance. Additionally, you should determine if a Qualified Charitable Distribution (QCD) of up to $100k from your qualified accounts is appropriate. Withdrawals from an IRA are considered income, where as a QCD is excluded from income. Keeping your taxable income lower may reduce the impact on certain tax credits, deductions, and Medicare costs.
The IRS recently announced a 7% increase for income tax brackets, new limits on Social Security taxable income, and increases in the estate, gift, and GSTT exclusions in 2023. Taxpayers with income near a marginal tax bracket may consider deferring income until next year or accelerating deductions into 2022. We recommend scheduling a meeting with your CPA or wealth planner to understand if these strategies are available to you.
Market Challenges Looking to 2023
High inflation is reducing purchasing power, increasing the cost of most items, and consumers are getting less for the same amount. It may make sense to hold off on major purchases and wait for higher interest rates to have an impact on items such as homes, buildings, and other assets affected by commodity costs. However, higher-than-average inflation over the next 18 months is unlikely to severely impact your long-term wealth plan. The average inflation rate for the last 30 years has been around 2.5%, and we use a more conservative number of 3% in our long-term projections.
What does inflation mean for you short term? To maintain your lifestyle, you may need to draw more funds from your portfolio or other sources than you would in a lower inflation environment. If your portfolio withdrawal rate is higher than your real return, that’s your portfolio’s return adjusted for inflation, and you are likely to deplete the portfolio over time. This may be okay; it depends on your objectives. Typically, you want to ensure that you can maintain your lifestyle throughout your lifetime and fulfill your wealth transfer plans and charitable bequests.
Concurrently, interest rates are rising, which is likely to cause variable debt interest rates to increase. Many investors took out HELOCs and lines of credit to remain invested in an impressive bull market and avoid taking capital gains… now is the time to revisit that strategy. Rates are rising which may reflect rapidly in your interest payments. It’s worth considering taking out fixed-rate loans if they are available to you. Home purchases may bring a staggering surprise for buyers: a 30-year mortgage is hovering around 7.8% right now, a much higher rate than what we’ve grown accustomed to. However, keep in mind that the average mortgage rate over the last 50 years was 7.9%. If you’ve found that perfect home, don’t let higher mortgage rates dissuade you from purchasing it. Should rates go down, which they have historically done after a rate increase cycle, you can refinance your mortgage at a lower rate.
Be cognizant that the effectiveness of wealth transfer strategies such as GRATs, IDGTs, Charitable Lead Trusts, and intra-family loans reduces as interest rates rise. Transfer strategies such as QPRTs and Charitable Remainder Trusts are more favorable for higher interest rates.
Wading Through Liquidity
Liquidity is crucial to financial health in times like these. You want to control when you liquidate assets to fund expenses, pay taxes, and fulfill your capital calls. Selling securities at a market low will likely lead to less-than-optimal outcomes for portfolio returns over time. It may wind up sacrificing the resilience of your long-term wealth plan. A sufficient liquidity amount is unique to each household, economic environment, and how much risk you are willing to take. In this context, risk refers to the probability of needing to withdraw from one’s portfolio. We suggest working with your Wealth Manager or planner to determine a liquidity amount that safely avoids ill-timed withdrawals from your portfolio.
Challenges bring opportunities, and the current economic environment is no exception. One tactic you may already benefit from is tax loss harvesting — selling securities at a loss to offset any taxable gains. Unused losses for this year may be carried forward indefinitely or until they are used; during this process, the portfolio is rebalanced toward your target. Losing positions can then be replaced with new investments that fulfill your allocation and avoid wash sales.
A down market is a great time to consider strategies that may improve planning outcomes, such as Roth Conversions and transferring wealth. Roth conversions allow you to transition IRA money, which you will owe taxes on later, to an account that you will not need to pay future taxes on. Converting at a market low allows the appreciation of the former IRA to grow in a tax-free withdrawal mechanism. While you will owe taxes on the converted amount, the total will be less now than if you had converted the entire amount at its peak.
Transferring wealth is a similar concept to a Roth Conversion: transfer at a low, minimize the use of lifetime exclusion or pay the lower gift tax, and hopefully, the assets appreciate outside of the estate. Remember, the lifetime exclusion will reduce from $12.06 million today to around $6 million after 2025.
Looking at Legislative Changes
The Inflation Reduction Act went into effect this past August, and it’s fair to say that the legislation contains many provisions that could impact your wealth plan and investment portfolio directly and indirectly. You can read more about the act’s impact and opportunities in our comprehensive deep dive clarifying the bill’s effects on wealth planning and investment strategies.
Looking ahead, the Senate is aiming to pass the SECURE Act 2.0 by the end of 2022. The House passed its version of the legislation earlier this year in March. While not yet finalized, Secure Act 2.0 is expected to include provisions such as increasing the Required Minimum Distributions (RMD) age from 72 to 75. This would be phased in over the next decade, rising to 73 starting in 2023, followed by 74 in 2030 and 75 in 2033. Because 80% of accountholders withdraw more than their RMD to maintain their standard of living, this really doesn’t help them. Rather, the delayed RMD benefits wealthy individuals who do not need to fund their lifestyle with retirement accounts by allowing for more tax-free compounded growth. Additionally, the bill increases QCD limits from $100,000 to $130,000 a year and changes catch-up contributions.
Separate from the SECURE Act 2.0 are IRS rule changes for Inherited IRAs RMD that are expected to go into effect next year. The IRS has pre-emptively waived any penalties for not taking RMD in 2021-2022. The rule changes would require non-spouse inheritors of IRAs to take annual withdrawals from the accounts during a 10-year period if the original owner died on or after his or her “required beginning date” for RMD. However, there are no changes to the Inherited Roth IRA 10-year rule; inheritors may keep the assets growing tax-free for 10 years, making it a more compelling candidate to pass on to beneficiaries.
All’s Well That Ends Well
Not all estate attorneys proactively schedule periodic reviews, and we encourage clients to evaluate their estate plans with their attorneys or wealth planners every 2-3 years in order to identify possible problems or opportunities before it’s too late.
Year-End Planning is also a good time to review beneficiaries listed on retirement and other accounts. Accounts ownership is often misaligned with the estate plan, which may cause issues when the owner passes away. At Robertson Stephens, we simulate the execution of your estate ahead of time to detect any account ownership issues.
Many have learned the hard way that end-of-year planning is not something to shrug off, as budding vulnerabilities may become major liabilities when ignored. You’re a year older. And if you haven’t changed, your environment has. Whatever the case, it’s time to have a conversation your wealth manager.