Wealth Strategy Report

Many tax planning strategies are contemplated based on the underlying economic environment. Whether a particular strategy will or won’t succeed is often dependent on economic conditions that are currently in existence or that may occur in the future. Three such economic conditions we’re currently experiencing are inflation, market volatility and elevated interest rates. Here, we discuss these economic conditions and explain how they may affect taxes and tax planning techniques. Specifically, we address various planning techniques that are favored in the current economic environment.

Inflation and income taxes

An inflationary environment can be mixed news for taxpayers. It’s often viewed as an additional figurative “tax” on individuals since it decreases purchasing power. However, it can have a real impact on actual tax payments on the federal and state level, particularly for individuals who’ve seen their compensation increase to address the effect of inflation.

Federal income taxes

The good news is that federal tax brackets and many federal tax benefits are adjusted for inflation. For instance, thresholds for determining the 0%, 15% and 20% capital gains brackets will increase, and the standard deduction, IRA contribution limits and retirement contribution caps will also be adjusted upward. But that adjustment, itself, might not keep pace with the inflation you feel. Due to a 2017 change in the manner in which the tax code determines inflation, the increase generally won’t be reflective of the actual change in the consumer price index.

There are also many tax items that aren’t adjusted for inflation, which can result in an increase in actual taxes paid. That’s the dark side of inflation. For instance, the threshold for determining whether a taxpayer is subject to the 3.8% net investment surtax is set at $250,000 ($200,000 for singles) and not adjusted for inflation. Had the threshold kept pace with inflation, it would have been set at about $325,000 ($260,000 for singles) in 2023. Thus, with incomes pushed up by inflation adjustments, more taxpayers will be subject to the surtax. The $500,000 ($250,000 for singles) exclusion from gain on the sale of a primary residence also isn’t indexed for inflation. In today’s dollars, the exclusion should be $961,000 ($480,000 for singles) to maintain its same value for taxpayers. So if inflation has increased the value of a home, a greater portion of its proceeds could be subject to capital gain taxes. Furthermore, the tax thresholds at which Social Security benefits are subject to federal income taxes also aren’t adjusted for inflation, so a greater portion of these benefits will be taxed in an inflationary environment.

State implications

Unlike federal rules, there are many states that don’t inflation-adjust their tax brackets, standard deductions or personal exemptions. According to the Tax Foundation, 15 states and D.C. fail to adjust tax brackets for inflation, 10 states leave their standard deduction unadjusted, and 18 states have an unindexed personal exemption. New York, New Jersey, Connecticut and Virginia are among the states that don’t index any major items in their tax rules.

Social Security

Payments to Social Security recipients are adjusted when the cost of living rises. These federal benefits increase when the cost of living rises, as measured by the Department of Labor’s Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Such was the case in 2023, when recipients saw an adjustment of 8.7% — the largest in about four decades. The 2024 increase will be a more modest 3.2% despite a slightly higher increase in year-over-year inflation. Along with a potentially higher payment comes the potential for a greater portion of the benefits to be subject to federal income taxes, as noted above.

Favored planning techniques

Tax loss harvesting

How this strategy works: Assets that have gone down in value may, depending upon your basis, be sold at a loss. Such losses might then be used to offset current or future gains realized elsewhere. After selling assets, if you want to remain invested in similar holdings, you can purchase such holdings, but beware of the wash sale rule. The wash sale rule is designed to prevent you from getting a tax benefit from a capital loss if you haven’t effectively changed your economic position (that is, you owned the stock before the sale and you still own the same stock after the sale).

Why it’s favored: In a volatile market (or one characterized by a narrow concentration of stocks that lead the market), some assets may have temporarily decreased in value below the acquisition cost, making them potential candidates for tax loss harvesting.

Roth conversion

How this strategy works: Traditional IRAs are primarily funded with pre-tax dollars and grow tax deferred. Generally, when you convert a traditional IRA to a Roth IRA, you’ll recognize ordinary income equal to the value of the assets converted from the traditional IRA on the conversion date. If the traditional IRA has any tax basis from after-tax contributions, the conversion income will be reduced by a portion of that basis.

Why it’s favored: Since a Roth conversion triggers income based on the value of the assets on the conversion date, if assets have declined in value, there would be less income recognized. Additionally, any recovery in the value of the assets after the conversion, as well as any additional future appreciation of any assets inside the Roth account, should escape future income tax when withdrawn from the Roth.

Portfolio rebalancing

How this strategy works: Due to changes in market valuations, your portfolio may no longer reflect your desired asset allocation targets. For example, your current fixed income allocation percentage may be less than originally intended. Accordingly, it may be advisable to make purchases and sales in order to restore your allocation goals.

Why it’s favored: If assets have declined in value and you’d like to rebalance your portfolio, it may be advantageous to do so while asset values are low. Generally, rebalancing your portfolio in response to a market decline is done to restore your portfolio to your target asset allocation. An added benefit is that the rebalancing process will typically result in reducing your allocation to assets that have either appreciated or declined by less, and purchasing assets that have declined substantially — effectively buying low and selling high.

Lifetime gifts

How this strategy works: Lifetime gifts may be made either outright or in trust. Such gifts may be made to lock in the current high gift tax exemption. The exemption is $12,920,000 for 2023 and will increase to $13,610,000 in 2024. Beginning in 2026, the exemption is scheduled to be cut in half, which we project to be about $7.2 million at that time. In order for gifts to lock in the higher exemption, such gifts must comply with the IRS anti-abuse proposed regulations, assuming the regulations are adopted as final. If gifts don’t comply with these rules, they may be subject to recapture (also known as “clawback”) at the time of death.

Why it’s favored: If assets have declined in value, it may be advantageous to make gifts while asset values are low. This reduction in value may be viewed as a tax-free gift, assuming that the value increases after the gift is made.

Qualified personal residence trust (QPRT)

How this strategy works: With a QPRT, you make a gift to family members (typically your children) of a personal residence (your principal residence or a vacation residence). You make this gift by transferring the residence to a trust and retaining the right to live there rent-free for a term of years. The trust cannot own any assets other than this residence, nearby acreage and secondary buildings, and cash necessary for near-future expenses. After the term of years, the house either passes to the trust’s remainder beneficiaries outright, or it can remain in trust for their benefit.

Why it’s favored: The calculations for a QPRT depend in part on an IRS rate that’s adjusted monthly (the rate in effect for the month the QPRT is funded would govern). QPRTs work best for transfer tax purposes in a high interest rate environment. During 2023, the rate used for this trust jumped to 5.8% from a low of 4.2%; an increase of nearly 40%. That’s because the value of your retained interest (which reduces the value of the gifted remainder interest) is valued greater in a high interest rate environment.

Grantor retained annuity trust (GRAT)

How this strategy works: A GRAT is an irrevocable trust to which a grantor contributes property and retains the right to be paid an annuity for a specified term. The assets remaining in the trust at the end of the term may either be paid outright to, or continue to be held in trust for the benefit of, the beneficiaries, usually children or other family members. At inception, the present value of the remainder is a taxable gift, the amount of which can be controlled by varying the term and/or amount of the annuity. The resulting value is based on an applicable interest rate published by the IRS each month. If the investment performance of the trust exceeds the IRS interest rate, that enhanced performance is in effect a tax-free gift to the trust beneficiaries. Unless the Grantor dies during the term of the trust, the trust assets won’t be includible in the Grantor’s estate for estate tax purposes.

Why it’s favored: If assets have declined in value, it may be advantageous to create a GRAT while asset values are low. This reduction in value will mean that a zeroed-out GRAT can be created based on a lower initial value of the assets. In effect, this reduction in value may be viewed as a tax-free gift, assuming that the valuation is subsequently increased during the term of the GRAT.

Charitable lead annuity trust (CLAT)

How this strategy works: A CLAT is a planning technique that can combine charitable goals with (i) wealth transfer planning and (ii) income tax planning. To do so, you would establish an irrevocable trust and fund the trust with assets such as securities. This can be done during your lifetime or upon your death. The trust will make an annual payment to the charity or charities that you designate in the trust, for the term of the trust. This annual amount can be a fixed amount, called an “annuity.” The term of the trust can be for a term of years or for the lifetime of an individual. After the trust ends, any remaining assets will pass to your named beneficiaries, generally your children, either outright or in trust for their benefit.

Why it’s favored: Generally CLATs are economically more favorable in a low interest rate environment but can also be favorable when funded with assets expected to appreciate. If assets have declined in value, it may be advantageous to create a CLAT while asset values are low. This reduction in value will mean that a zeroed-out CLAT can be created based on a lower initial value of the assets. In effect, this reduction in value may be viewed as a tax-free gift, assuming that the valuation is subsequently increased during the term of the CLAT.