First Republic Fall Forum Session 2: Tax, Financial Planning Considerations and Strategies

First Republic Bank
September 23, 2020

Watch part two of our series of conversations designed to explore the geopolitical landscape, U.S. presidential election implications, and key tax and investment considerations with Richard Scarpelli, Head of Financial Planning, First Republic Private Wealth Management. Brought to you in partnership with Eurasia Group, one of the world’s leading global political risk research and consulting firms.

Read below for a full transcript of the conversation. 

Chris Wolfe - Okay, good afternoon, everybody. And welcome to what is the second in our series of the First Republic Fall Forum. We're going to have four, potentially five of these, devoted to the issues around the election, taxes and the capital markets and the implications that may show up either in your personal portfolio or more broadly across the economy. Now, our first webinar was held last week and that was focused on policy and politics with John Leber from Eurasia Group. And I'm pleased to introduce Rich Scarpelli who's the head of our financial planning here at First Republic to talk about the second in our series, which is taxation. Now, there's a lot going on here. So what we're going to do is share a presentation, some materials, Rich will go through it, spend some time talking about some of the important nuances that may be interesting opportunities for clients to consider. And then we'll turn to some Q and A towards the end. So that's the format for our discussion today, and I'm going to turn it over now to Rich. Go ahead, please.

Rich Scarpelli - Thanks, Chris. Thanks for the warm introduction. Really a pleasure to be here. I'm going to share my screen right now. There's a number of things, there are a number of things that we're going to touch upon in the tax world. Just give me a second to share. Okay, pull that up. Taxes, and the topic is near and dear to my heart. I actually love talking about taxes. I've been in the business for over 20 years, talking about taxes and helping clients in their tax situation. In fact, I love it so much I actually married a tax accountant. That's a little fun fact about myself. One of the things that really stand out in all the conversations that I have about an individual's tax situation is this question of, do I accelerate income? Do I get taxed today? Do I get tax tomorrow? Do I defer deductions? Do I accelerate deductions? What's the timing of it all? And timing has a really, really important role in all of this. And we're going to be touching upon many things in the tax code that relate to timing and one's time horizon. So our objectives for today, we'd like to start by summarizing some of the potential tax changes that could be coming down the pike, with the election, with the government spending, et cetera. But we'd also like to provide a high-level overview of some tax management techniques, by making you aware of some income tax strategies that are out there, some estate and gift tax strategies, and everything that I'm going to be talking about today, it's in the code. So it's not some tax loophole, some, these are actually in the code and they were designed to achieve the objectives that they were made for. I'm also going to touch upon the impact that some of these strategies have. I'll show some graphs, some charts so you can visually get a sense of the tax advantages that it may have in managing your tax situation. And I think the most important, I'll be covering some topics that you just may not be aware of. But at the same time, they're not going to be relevant to everybody. They just may be relevant to some of our audience today. But really important that you understand what they are and the role that they can play. Because if they do apply, it could be very, very meaningful. So with that, let's talk about taxes today and taxes tomorrow. I'm just going to talk about a few of these taxes, the primary ones. We have a top income tax bracket today of 37%, which hopefully everybody is aware of. On the capital gain side, for long-term capital gains, we have a top rate of 20%. Many times the net investment income tax is also applied to these gains. And that tax is an additional 3.8% tax, so many times you'll see the long-term capital gains top bracket quoted as 23.8. We have a federal estate tax exemption of close to $11.6 million. That's an exemption amount where individuals either during their life or at their death can pass assets to beneficiaries and the heir’s estate and gift tax rate. So we'll be touching upon this towards the end of our conversation today. And then the federal estate tax rate is currently 40%. So this is what's in existence today. What could the future look like? And there's one thing about taxes that are constantly changing. Constantly changing. So taxes tomorrow? We could very well have a top income tax bracket of 39.6, which you've had in the past. It should be no surprise to anybody. We could very well have a long-term capital gains tax of 39.6 as well, matching the top income tax bracket. We could have a federal estate tax exemption. Actually we will have a federal estate tax exemption of $5 million, because that 11.6 is set to sunset at the end of 2025. And starting in 2026, that exemption amount will go to $5 million under current law. More than likely to be changed in some way, shape or form. There's even talks of it going down to $3.5 or maybe even lower than that. And then there's the federal estate tax. So who knows what it's going to be. It could be as high as 55%. It could be lower at 35%. We've seen it fluctuate. But the really important aspect on the federal estate side and the estate tax side is that exemption amount. That's critical to a number of individuals out there. A big theme as well when it comes to taxes is when to pay and do I pay them early, do I delay payment? And there's one general rule that I've tended to stick to, and that's never pay your bills earlier than you have to. You want to pay your fair share. You want to pay it in a very timely manner. But why pay sooner than you have to? So a major theme generally, you don't pay the IRS sooner than you have to. It's generally best to defer that tax payment as long as you possibly can. However, there are going to be exceptions to this, and we'll touch upon some of those exemptions, exceptions where it does make sense. Because the power of income tax deferral is really tremendous. And in our next slide, let's pull up a graph here. And so we have a gray line that shows post-tax wealth, wealth accumulating over time, as well as the income taxes associated with that wealth accumulation being paid over time. It puts a little bit of drain on overall wealth. And that top line, that goldish line, is pre-tax wealth, wealth growing in a tax-deferred and or tax-free manner. And at the end of a longer period of time, that differential just gets bigger and bigger. And at the end of this time period, you would need an equivalent of a 46% reduction in that value to equate to that post-tax wealth. So tremendous compounding effect, if you can defer tax payments out, out into the future. All right, so let's go jump right into it. What can we do? What can we do today? On the income tax side, we break it down into three categories. We can defer, we can accelerate, or we can mitigate taxes, really manage your tax situation accordingly. And again, knowledge is power in all of this. And on the estate tax side, the major theme right now is flexibility, flexibility, flexibility. We don't know where that exemption is going to go. There are a number of individuals that want to take advantage of, or potentially take advantage of a higher exemption. And so you want the flexibility to do so. We're going to be touching upon that at the end of the presentation. So let's talk about deferral. One of the best mechanisms to defer is to contribute assets, liquid assets, to tax-deferred accounts. Many out there are familiar with individual retirement accounts, IRAs and Roth IRAs. There are also 401k plans that are very prevalent nowadays. And I just want to run through some of those contribution limit, and something that folks may not know or be aware of on the 401k side. So hopefully many are familiar with the maximum amount that you can contribute to a 401k, which is 19,500, or the known maximum, right? You can go above that actually. And for those 50 and older, you have an additional catch-up contribution of $6,500. But I want to stress that it just doesn't stop there. There are many individuals that stop at the 19,500, in addition to the catch-up contributions, again if you are 50 and older, I want to highlight this number right here, this $57,000, because that's the total amount that can be contributed to a defined-contribution plans either by yourselves in addition to any employer contributions. So how does this work? I want to show everybody an example. So Alex here is 50 years old. He has a base salary of $225,000, and he really wants to maximize his 401k contributions this year all the way to the max, the 57,000. The employer does have a matching contribution, so he's going to take advantage and max out on that contribution, up to $9,000. So we'll assume that. And Alex is going to elect to really contribute a certain part of his pay that maxes everything out. So let's start with the regular contribution of 19,500. It's an amount that's pulled from Alex's paycheck. He contributes it. He's either going to contribute it typically to a regular 401k plan or a Roth 401k plan, right? There is a difference between the two. A regular 401k plan, its pre-tax dollars going in, dollars that have not been taxed yet, they'll grow on a tax-deferred basis. And when those assets are distributed, more than likely in retirement, that's when the income tax hit occurs. For the Roth, which is very similar to Roth IRAs, what I'm describing, for the Roth 401k, if you have that option at your employer, you're contributing after-tax dollars. So that 19,500, they already paid the tax side, those funds will go in, they'll grow on a tax-free basis. And when they're distributed out of the Roth 401k, it will be completely tax-free. You will not pick that up in income. So Alex here contributes 19,500. There's an employer match at 9,000. So what is this extra 28,500? That's after-tax contributions that Alex can make to the 401k plan. So if Alex has the wherewithal and has the ability to put away extra savings, he can elect to defer or contribute on an after-tax basis, again dollars that have been taxed, to the 401k plan, an additional amount of 28,500. The 57,000, that's way above the $19,500 limit. So for those that weren't aware of it, you do have that option to put it into the 401k. Okay, so let's move on. There are two other great mechanisms to really sock away retirement savings or additional retirement savings and that's through life insurance and annuities. They're not counselor contracts. And you could, depending on the type of contract and specifically the type of insurance, there are many types of insurance out there, term insurance, permanent insurance, which could be whole life universal life, and really talking about whole life policies and universal life policies, like variable life policies, where cash value accumulates and you have the ability to direct some of your investments in there and investment options. And those assets can grow on a tax-deferred or, and or tax-free basis, if it's structured properly, in these a life insurance contracts and annuity contracts. Generally speaking, life insurance, it's a great mechanism to protect your family and your income as well, utilizing those proceeds. As they also mentioned, it's a great mechanism to save additional funds for retirement, if you want to pull it out and you didn't necessarily, or relying on that for the life insurance proceeds itself for your family. Just a little tidbit here. Don't assume you can't get coverage nowadays. There are many out there I've run into that assume they cannot get coverage. You can get coverage. Definitely speak to a life insurance professional. We have them here at First Republic. Or if you already have one, definitely consult with your life insurance professional on that. Now annuities is another contract where you can, again put away dollars and they'll grow in a tax-favored manner. On the annuity side, when I generally think of annuities, I really think of filling the income gap in retirement. What does that mean? So some individuals are relying on social security and maybe relying on a pension, maybe they have a job in retirement, they're collecting some W-2 income, but it's just not enough to meet their expense needs and they would have to pull from their portfolio. And that could very well be a stock portfolio, stock and bond portfolio. It's subject to the volatility of the markets. And it just doesn't help them sleep well at night, knowing that part of their income is coming from that side of their assets that could fluctuate and potentially significantly with the ups and downs of the market. So they look to the annuities, the annuity contracts, as a guaranteed source of income to fill that gap, and it definitely makes them sleep well at night. I know, personal example, my father. You know, we were going back and forth talking about it. And he said "Rich, it's just going to make me "sleep well at night." So do it, get it done. And definitely it's tax advantageous. So these, in summary, life insurance annuities, a way to increase retirement savings, a way to minimize the impact taxes have, get that tax-deferred growth, as I was showing in that graph in the beginning. And then you could potentially even receive tax-free withdrawals from each of these, if they're set up appropriately. So another great mechanism to manage tax liability in a fairly easy, uncomplicated way. And that's what I want to stress here. So let's talk about accelerating income tax. I guess, what I was saying in the beginning, there are times where you do want to accelerate and there are exceptions. One of the biggest questions that I've gotten over the last weeks and actually a month, a month and a half, is around capital gains. So I showed you before that those capital gains rates could jump from 20% or 23.8% all the way up to 39.6. That's a big, significant jump. And there are folks contemplating, well, do I pick up the gains now? Do I get tax now? Because we know that there's definitely a big difference in the tax bill. In fact, in this scenario where hypothetical illustration taxing $200,000 of long-term gain at 23.8% in year 2020, its approaching 50,000. And if we have a rate of 39.6 in year 2021, you're looking at about a $32,000 tax increase, a pretty significant amount, seems like a slam dunk, and no brainer. But I would say, Hold on a second. "There are a number of additional factors "you need to consider as well." I mean, if you could predict the future perfectly, and if you knew you were going to sell next year and that rate was definitely going to be 39.6, then, yeah, take advantage of the lower rates now, pay the lower bill now, it is significant enough. But you need to accurately predict the future. There are other factors to consider. And I've run through a number of them. Generally, deferring the payment over a longer period of time is that advantageous, as per that graph I showed in the very beginning. You know, and doing it prior to the election, maybe a little premature. After the election, we may have a little more clarity on the direction that taxes may go. You know, the U.S. Senate elections definitely are going to impact any tax plans that are maybe in the works. And you also have to question if Biden was elected, will his exact plan come to fruition? And if Trump's reelected, what changes is he going to need to make in order to maybe balance budgets or deal with the increased spending that has been occurring. You can definitely gain more clarity after the election. Consideration should also be given to capital losses. If folks have significant carryover losses or they have unrealized losses, maybe they're able to integrate those. And it's less of a big deal to maybe accelerate the recognition of that income, especially if you really can't predict the future. What income tax bracket are you going to be in now? What income tax bracket are you in now? And what bracket will you be in, in the future is going to impact that as well. We don't know, for those making a certain amount of income, the capital gain rate maybe 15%, it could still be zero. You just don't know. So you'd have to do a little prediction there as well. This is a big one. What's your charitable intent? Many folks, probably on this call, they give away to charity, maybe they give cash. There are many times we would recommend clients donate stock that has a very large long-term capital gain in it or short-term capital gain, because the recipient, that charitable organization, is a tax-exempt entity and so they're able to take those investments, sell them, not recognize any gains, and then use the proceeds to accomplish the mission of that particular charity. So if you're giving away stock to a charitable organization, maybe an irrelevant question, do I recognize gains now or later? There are also those individuals that will give away the stock, have the wherewithal and the means to give away the stock and then just repurchase those investments, those shares for themselves. And what does that accomplish? You've basically given away the capital gain and you've taken on the same position with a higher basis. So your embedded gain is basically zero. You're starting from scratch. And you still have exposure to the security. Does basis step-up at death come into play? So when one passes away, all the embedded gains in a number of assets completely go away, because your cost basis has stepped up to full fair market value on the date of death. Now there's also some question to, is the basis step-up going to go away if tax laws are changed? It may, it may not, but that has to be considered. Also, are you on a gifting program? Do you have an annual gifting program where you gift to family members in potentially a lower bracket? And maybe they can take advantage of the lower capital gains tax bracket that they're in, as opposed to yourself. Then you also have to ask yourself, "Do hedging strategies come into play deferral strategies, "such as exchange funds "and see a charitable remainder trusts?" Those are vehicles where you can contribute capital gain property that has a large capital gain, diversify out that position. Many times individuals will utilize these strategies for concentrated equity position that has a large gain. They just really are uncomfortable recognizing such a large gain where you can sell within these vehicles or donate it, get some diversification, and then defer that tax liability out into the future. Again, tried-and-true strategies that are available and commonly used in our business, in the tax business. So switching gears a little bit. I wanted to touch upon something that I've been talking about since really the beginning of the year, and gained some traction as markets were dipping and they've recovered somewhat, but this is the concept of converting a traditional IRA to a Roth IRA. So what I was saying in the beginning, when I was talking about the 401k. With the traditional IRA, almost acts like a regular 401k, the traditional IRA, you're generally contributing, okay, pre-tax dollars to that investment account, and it's going to grow on a tax-deferred basis. And when it's distributed, hopefully in retirement, that's when you'll pick up the income tax. The Roth IRA, and just to repeat myself, it's a little bit of the flip, where you contributing after-tax dollars, it's growing on a tax-free basis, and it's going to be distributed tax rate. So you can get a tremendous compounding effects by the Roth IRA and that tax-free compounding growth and distribution. So why take advantage of this? Again it's for the tax-free growth. I want to touch upon three main factors that are driving this, why I've been talking about it so much. The first factor is that current rates are lower now compared to, or potentially lower now compared to what they may be in the future, regardless of who wins the election, given all the spending that's going on. So tax rates come into play. Additionally, this may very well be a low income tax year for a number of folks. We know incomes have declined. So you're potentially in a lower tax bracket. There are business owners that may be on this call that have net operating losses or much lower business income. So they're in a much lower bracket, or were not paying any income tax at all. What a perfect opportunity to make a conversion. Because again on the conversion, you can be paying that tax immediately, you're taking a distribution from your IRA, being taxed on it today, and you're putting it into a Roth IRA to get that tax advantage growth. And quite simply, the account value today may be lower than it is in the future. So if you were contemplating this and thinking about it, not only do taxes come into play and you could be in a higher tax bracket or subject to a higher rate in the future, but also that account value could be larger. It could be much larger in the future. So your tax bill will be larger on the conversion. So now may be the best time to convert that traditional IRA to a Roth IRA. Let's look at an example. I'm going to bring up some, a chart here. I just want to touch upon there. Many folks, maybe out there, with the understanding that there are income limitations for contributing to a Roth IRA. That is absolutely true. So there are a number of individuals, if they hit a certain income threshold, they're not going to be able to contribute to the Roth IRA. But for a conversion, those income limitations do not apply. You can convert as much as you can from your traditional IRA to a Roth IRA. All right, so let's jump into an example. Richard, unrelated to me, is 49 years old, lives in California, I live in New Jersey, and is in the highest federal income tax bracket. He has a $500,000 traditional IRA and a taxable investment account of $250,000. Now, why is that important? Why do I include, in this example, the taxable investment account? And that's because where this makes a lot of sense is that tax bill on the conversion that you pay right away should come out of outside assets, assets that aren't in that traditional IRA. That's when it makes most sense, okay? So you have to have the liquidity outside of the IRA to cover the tax bill. So I'm considering, Richard, unrelated to me, is considering converting his traditional IRA to a Roth IRA. And we're going to assume the growth rate on these accounts is 5% and there's some turnover in that taxable account. 20% of the growth is taxed each year. Now let's take a look at some of the, the graph here. And so we'll see the gold line is the Roth IRA. And I want to stress that, in the beginning, the Roth IRA has taken an immediate hit, and that's because the tax bill is due on conversion. Take money out of the traditional IRA, I'm paying it out of the 250,000 that I have in the taxable account, so I'm almost close to a starting point of $500,000 in the Roth IRA all the way down at the bottom left. Whereas the traditional IRA, as well as the taxable account of $250,000, my starting point is 750. So as I go along here, the traditional IRA is outpacing the Roth IRA on a pre-tax basis. And I'm not showing the tax effect as we go along on the traditional IRA. However, in around year 2020 to 2043, we see this little blip. Well, what is that? Well, that's when I have to take out required minimum distributions out of my traditional IRA. So in order to compare apples to apples, I also take those distributions out of the Roth IRA and I'm saving those. But you'll see a greater blip in the traditional IRA as opposed to the Roth IRA. And you can see, after that point in time, because I'm starting to pay the taxes, that that gap is narrowing. So the longer the timeframe, the more beneficial the Roth IRA becomes and sooner or later it's going to cross over, right? So yeah, you really have to have a long-time horizon, a long-term perspective. But we need to look at this in a different way as well. So this is, looking at the traditional IRA on the pre-tax basis, well, what if I need those funds right away or 10 years out or 15 years out? So you really want to look at this on an after-tax basis as well, after-tax values, as highlighted by the headline in this slide. And here are my starting point, is the same, because I'm tax affecting both of these. I convert the traditional IRA to the Roth IRA, I pay the tax, my starting point is almost $500,000. I'm looking at the traditional IRA, as well as the taxable investment account of 250,000, I'm tax affecting the traditional IRA, my starting point is the same. And over the period of time, on looking at the after-tax values, the Roth IRA is really outperforming the traditional IRA on an after-tax basis. So what's the bottom line here? The bottom line here is if I have a long-time horizon and I'm going to leave those assets alone and not really take distributions until I have to, the Roth IRA makes a lot of sense. I really should consider converting a traditional IRA to the Roth IRA. However, if I have a shorter time horizon where it's over the next five years or six years or three years I'm going to be taking out of the traditional IRA, why pay the tax now, right? Why pay earlier than you have to on the conversion? However, you also have to consider where our rates are going to be. Am I going to be in a higher bracket later on as opposed to now? So that comes into play. But generally speaking, if you're looking at a shorter time horizon, you withdraw those funds, stick with the traditional IRA. Okay, here's two elections that may save you taxes. Going to move on from IRAs and Roth IRAs. But it's not going to be for everyone. And these are two elections that are really very specifically for those individuals that have equity compensation awards, like restricted stock, restricted stock units, employee stock options, non-qualified stock options, incentive stock options, et cetera. So it really, really applies to those individuals that have these awards, whether they're from a private company or a publicly traded company. Well, they may not apply to all publicly traded companies, and you'll see that in a second. Well, the first one is an 83b election. It's Internal Revenue Code Section 83b. It's an 83b election. And what the intent here with this election, is if you received restricted stock, for example, you wouldn't raise your hand. And even though you're not vested in this stock and the tax event didn't occur, or maybe it's not going to occur for five years, or four years, or six years, whatever it may be, you want to raise your hand and you say, you know what? Tax me now, IRS. Government, tax me now. I'm willing to pay the tax on it. And I'm willing to pay the tax on that dollar. And it's only valued at a dollar. Tax me now, I paid 40 cents on the dollar. No problem. Even though the tax event isn't set to occur for five or six years. Because I know, deep down, that it's worth a dollar today, but in five years, when it vests, it's going to be worth 10. And when it vests, that's when the tax event occurs, typically occurs, and you pay ordinary income tax on that, on that tax event. So you pay an ordinary income tax on $10, and ordinary income tax on the dollar, right? So if you make the election, you pay the tax on the dollar in any subsequent appreciation there, there would be capital gain and treated as capital gain. So you're really converting ordinary income, the intent is to convert ordinary income to long-term capital gain with this strategy, not strategy, but with this election. And it does have to be made in a timely manner. And if you think that it applies to you, definitely reach out to your tax accountant. I should've been saying that all along. Definitely reach out to your tax accountant on anything that I've been discussing today. They should be aware of it. They should be. The other election is an 83i election, okay? This is really available for those who have restricted stock units, non-qualified stock options. And the intent here is to defer the income tax payment for up to five years. But again, it's not for everybody. So if you have publicly traded stock, that's the underlying, it's not going to be available. If you are part of executive management, it's also not going to be available to you as well. Let's move to mitigate. Moving along here. I want to touch upon something that, again may not be well known to all. And in fact, some accountants aren't aware of this. It's called qualified small business stock. So what is qualified small business stock? If you have this stock, it could potentially receive preferential capital gain treatment. This is 1202 of the code, Section 1202 of the code, it's in the code, where you can exclude the greater of $10 million of gain or 10 times your cost basis, whichever is greater. But the stock must meet certain criteria to qualify for special treatment. It's got to be qualified. The stock must be a C corporation and must be acquired by original issuance. The stock must be acquired after August 10th, 1993. That's when the law was put into place. The gross assets of the companies, when you actually receive the shares of stock, cannot exceed $50 million. So it really truly has to be a small business or started off as a small business. It could be a very large business now. It be a billion dollar company or a multibillion dollar company, but when you acquired it, it had to be a small business. And there are certain types of businesses that do not qualify. Some service businesses, a lot of businesses in the financial services industry, et cetera. So let's run through a quick example. So you can see the impact and how it works. Jennifer, and I'm going to use an exaggerated example here, where Jennifer has realized gains of close to $30 million, has $28 million of gain. Jennifer, a while ago, invested $2 million in a business. So her basis was $2 million. And right now, she sold that for $30 million. And so right off the bat, we have to calculate what gain is eligible to be excluded. And I said before, it's the greater of $10 million or 10 times your cost basis. 10 times, Jennifer's cost basis is $20 million, it's greater than 10, so we're going to exclude that gain. However, that portion that's excludable is going to be subject to further limitations, and I'll run through that in a second. The remaining $8 million is going to be Non-Section 1201 Gain, it's going to be subject to the normal, regular long-term capital gain rate of 23.8%. And I have added the net investment income tax in that. So let's bring up the total tax due. And I want to talk about how that $20 million of eligible gain, it's not all of it, can be excluded. It really depends on what I just circled here. Whether it's subject to a 50% exclusion where only 10 million of that gain can be excluded, or a 75% exclusion where only 15 million of that gain could be excluded, or 100% exclusion where all of the $20 million gain will be completely excluded from income tax. What's going to dictate that is when you acquired it. So if you acquired it after September 27th, 2010, you will receive 100% exclusion of that $20 million and your tax will just be on the $8 million. That's not excludable gain. And so that total tax would be close to $2 million of gain. You know, the timing is really important on that, because there are other dates that are applicable for the 50% and 75%, which are earlier than that 2010 date that I just mentioned. And when you factor in state income taxes, that 50% and 75%, there are many times, it just, it didn't really make that of a difference where it was worthwhile to go through the exercise of qualifying the stock. But I want to make sure everybody's aware that qualified small business stock exists. It's out there. If you think you have it, talk to your accountant. I've seen some accountants miss this. All right, just really quickly, two other tax management strategies that folks may not be aware of. I want to talk about net unrealized appreciation really quickly. There are many of you that may have a 401k plan out there. And that 401k plan allows you to invest in the publicly traded stock of your employer. And you've been doing so for a long period of time. And it's grown significantly over a long period of time. And that fund in there of employer stock has a large embedded capital gain in there. But guess what, if it's in the 401k and you take a distribution of those assets, like I said before, it very well be ordinary income to you on that distribution. So this is a mechanism where you can make an election. You can say, you know what? I want net unrealized appreciation treatment. I want to take a lump sum distribution of that employer stock. I want to receive the shares. Not cash, I want to receive shares. The government allows you to only be taxed on the basis of that, okay? The fund's basis in that. So if that basis is really low, 10%, 15, 20, 30% of the fair market value, you'll only be taxed upon that amount. And any of that appreciation that's been accumulated over a period of time will be capital gains when you actually sell the stock. So this is a mechanism to convert ordinary income to capital gains. I also briefly want to mention a little bit about an employee stock ownership plan. So net unrealized appreciation pertains to employees. On the employer side, you're a business owner, you could potentially sell your business to a retirement plan, an employee stock ownership plan, all right? And if you invest those proceeds, in what we call a qualified replacement property, it's in the code, we're not going to go down that path to run through all the nuances of this strategy, but you can defer the recognition of that long-term capital gains tax. I will say this. I have not seen too many of these in the last 20 years or so. It's not very common. It really has to be right for you, right? It's not applicable to everybody. But you do have the ability to defer long-term capital gains tax on a sale to a retirement plan, an employee stock ownership plan. All right, we're going to finish up on the estate tax, and I just want to touch upon one thing, Chris, on the estate tax around flexibility, flexibility, flexibility and that's the concept of intrafamily loans. Intrafamily loans, what is it? It's where you, you make a loan to family members. And the family members make loan payments back to you. What's critical here is the interest rate that's being applied to these loan payments. Because why do you want to do it? You want to take advantage of low interest rates for wealth transfer purposes. And these interest rates aren't made up, aren't fictitious. The government issues these interest rates once a month and they are very low. And it's the bare minimum interest rate that needs to be applied to these loans. So for a one to three-year loan, you're looking at 0.14%. 0.14, not 1.4, not 14.1, 0.14. For a loan that has a term of three to nine, you're looking at 0.38%. Okay, so really, really low rates. And so the idea is, in an example, I make a $2 million interest only loan to my son at 0.38%. My son is going to take those loan proceeds, invest them, they're going to grow at a rate of 5%. He's only paying me back 0.38, and he's going to pay me back principal at the end of the five-year period. So once my son left with at the end? $510,000, essentially given to him estate and gift tax-free. So Rich, where does the flexibility come into play? Here's where it comes into play. I think the exemption is going to go down to a million dollars. I'm like, "Oh, the exemption is going to go down to a million, "I really can afford to give away the full two million, "let me just forgive the note." You have the flexibility to utilize your gift tax exemption at any point in time. That's the 11.6 I was talking about. You know, in this strategy, it's utilized with trust structures and promissory notes and potentially sale of assets. But I just want to kind of emphasize a few things with respect to this. If you are thinking of a wealth transfer strategy and you want to avail yourself of higher exemption amounts, it's really critical that you get your trust structures in place. Attorneys are already busy, trust companies are already busy, you really want to be very proactive and get those trust documents in place so you can pull the trigger when it's time to pull the trigger. All right, wrapping up. Best key takeaways. Generally, you want to defer the recognition of taxable income as long as you can, except where it makes sense. You want to consider maximizing contributions to retirement plans. IRAs, 401ks, et cetera. You want to consider life insurance and annuities, also another mechanism to manage taxes. Consider the conversion from a traditional IRA to a Roth IRA. Take advantage of tax elections and special tax treatment. We talked about employee stock ownership plans, net unrealized appreciation, qualified small business stock, 83b election, 83i election, just touching on a few things in the tax code that exist in the tax code today. And then you want to consider wealth transfer techniques, using promissory notes and trust structures. Well, that was the lot of this. I covered a lot. I think it's time for questions.

Chris - Rich, that was excellent. There's so much going on there. And I know that's probably just scratching the surface. I think the good news is that there's a lot of questions. I'm going to try to bring a lot of them together so that we get some of the ones that are closely related together. So let me start on the Roth section. There's just seems to be a lot of questions around all of that. You've touched on a couple of things. So one of them, for example, was a backdoor conversion related to that, might be things like Roth 401ks and the likes. Maybe you can just go over some more specifics around all of that.

Rich - Yeah, so you bring up an interesting term. Backdoor Roth. A lot of people talk about it. And that occurs is when people can make a nondeductible or deductible contribution to an IRA. And there are many times they actually are participating in their employer plan or they're over the income limits and they can't contribute to a Roth IRA. And so what they'll do is they'll contribute a nondeductible contribution to a regular traditional IRA. So they, in essence, have basis in this traditional IRA and then they'll immediately convert it to a Roth IRA. And so when you convert it, you have full basis, you're not going to recognize any income tax on that conversion and it's a backdoor for those high income earners to establish a Roth IRA that would otherwise be subject to the limitations that are in place to a Roth IRA. However, those folks do have a traditional IRA. There may be some income tax. And so you kind of have to aggregate all your traditional IRAs and parts of other IRA accounts would be subject to income tax. You're going to have to allocate, you have to do it on a pro rata basis. You can't just take one specific account that has nondeductible contributions and convert it. So the government says not so easy. You know, they say, No, not so fast. We want to tax you.

Chris - So that's, it reveals two things. One, there's a fairly high degree of complication there. You definitely have to talk to your tax advisor about your specific situation. But also leads to some other questions. So you think about conversions, but also kind of advantageous levels. Are their dollar levels, income levels, or anything else that make a Roth more advantageous and say something else? Or is it always and forever that's a good idea? So how do you see that?

Rich - Right. It really has to do with timing and what your expectation is. When are you going to take assets out? And the timing that you're going to trigger the taxes. You know, generally speaking again, anytime somebody is talking taxes, it's always the word generally before generally speaking. Roth is a good idea. Is definitely a good idea.

Chris - Okay. One question that's come in about the 401k plans example that you made earlier. So that before tax contributions and the after-tax contributions. The number you came up with was 57,000 in the example, but the property of having before and after-tax contributions is that common to all 401k plans? And you said if you have someone with the wherewithal, they should do that, is that generally the way things should work?

Rich - Yeah, not all 401k plans have all the options that I was talking about, Roth or regular. Not all 401k plans have a conversion feature. So I was talking about IRA conversions, and there are many folks that would contribute the after-tax amount, the 20 some odd thousand dollars that I was talking about, to get you up to the 57. And if your plan allows for it, they'll take that, and they'll convert it to a Roth 401k, if they have that ability to do that. So that's highly advantageous as well to those individuals who want to do it.

Chris - Just staying on the Roth topic. I'm sorry, there seem to be a lot of questions around this. If you make a nondeductible contribution to a regular IRA, should you do the conversion?

Rich - Oh, you can. It really depends. Because like I was saying before, if you have other IRAs where you gave deductible contributions or there's a lot of taxable income that would be in there, if it was distributed, you're going to have to pay taxes on a pro rata share. You can't just convert that nondeductible amount. So you have to be careful. But generally speaking, if that's the only thing you own, it makes complete sense to convert that amount. Do it right away.

Chris - Got it. So I'm just going to keep going at the Roth questions. They just keep coming in. So these are good. And then we'll get to some of the other ones that have come in so that we don't spend all our time on Roth. So for Roth contributions, if your income is over the limit, can you still contribute or should you just do something else with the capital?

Rich - So if you're over the limit, if you're over the income limit, you can't contribute to the Roth, okay? But like I said, you can do the backdoor. You can backdoor it by contributing to your regular IRA or open up a traditional IRA, make it not deductible contribution, then do the conversion, because you're not subject to the income limitations on the conversion.

Chris - Got it, got it.

Rich - And if you didn't want to do that, like I said, there are other avenues. You can look at annuities. You can look at life insurance contracts to sock away dollars that grow on a tax deferred basis.

Chris - Got it, okay. Let's shift gears a little bit too some things around 83b's, that's the tax code area. So I think there's a couple that have come in. We'll start with the big ones. Any disadvantages to making an 83b election, meaning you have to go do it? Does it cost you something? What are the disadvantages there, because you explained the advantages.

Rich - Yeah, yeah, I did. It sounded great, right? Like, "Oh you should do it," right? But keep in mind, you're accelerating the income tax payment. So you're paying it and it's gone. And meanwhile, you don't have the underlying security. It's really not yours. There's a substantial risk of forfeiture. So you may never get it. Company goes belly up. Guess what? You just lost. Or the value goes down, you can't recoup that tax payment. It's not like you can refile your return. That tax payment is lost and gone, number one. Number two, where folks went into difficulties, it sounds great but you have to come up with the liquidity to pay the tax. So you have them taxed on the dollar or the $2, I still have to come up with the 40¢. And if I don't have it, that's a problem. So those are the two things that have to be looked at.

Chris - Liquidity and cash, okay. Can you make an 83b election on privately held stock or private company stock?

Rich - Yeah, that's an easy one. Yes, you can. Yes, you can. But you've run into the liquidity issue.

Chris - Got it.

Rich - You have to be careful with that liquidity issue.

Chris - So let's shift one letter over a few letters over from b to I. So we'll go from 83b to 83i. You talked about being an officer specific around that, can you be more specific if an officer of a nonpublic company, can they use an 83i election?

Rich - No, they can't, anybody in the C-Suite. So if the code isn't very specific, but it's clear enough where if it's the CEO, the CFO, chief marketing officer, anybody in that C-Suite it's not going to be available to them. Again if it's publicly traded stock, it's not going to be available. That section was really designed for those individuals that don't have the wherewithal, the liquidity, to pay the tax investing, like I was talking about with the 83b election, the liquidity. So those employees that received it, but they just can't pay the tax. So the government's like, we can give you a break. Let's stretch it out over a five-year period. You can pay at the end of five years.

Chris - Got it. So not available for nonpublic company.

Rich - No, available for nonpublic, it's not available for public.

Chris - Got it, got it, got it.

Rich - Hopefully I said that correctly. Right, not available for a publicly traded company, yup.

Chris - Let's go to an easier question then, which is around taxation on stock options when you receive them. Are you taxed when you exercise or when you sell?

Rich - Okay, so you're not taxed when you're given them, okay? You are not taxed when you vest in stock options. You are taxed when you exercise. And if you have non-qualified stock options, that's going to be ordinary income when you exercise those options. That exercise is going to trigger the tax event. If you have incentive stock options, okay, you're not going to pick up ordinary income when you exercise. However, it will be an add-back for alternative minimum tax purposes. So you could very well get hit with an AMT. If you have ISOs, incentive stock options, pardon me, you definitely want to talk to your tax accountant, because you're going to have to keep track of your alternative minimum tax basis and then you're going to have to keep track of your regular tax basis. By more than, if folks want to know, but the tax event occurs to that exercise.

Chris - That's a good place to, a good thing to remember. A tax event occurs at exercise. So that's really good. Staying on the topic of kind of businesses, business stock, et cetera. How would someone know if they had qualified small business stock to even get to that election?

Rich - Yeah, that's a really great question. And folks may not even know that they have it. You know, we, when we've run into folks that have, yeah, sometimes they have the ability to go back to the company, the company should've been keeping track of it, keeping books and records when they issued the stock, making sure that the gross asset tests, $50 million or less, right, on their $50 million was documented. It's got to be a C corp when you received it, right? So you want to make sure it's a C corp. And so really you got to go back to the corporation. The corporation should've been documenting that it in fact was qualified small business stock. You may very well not know, and you'd have to talk to somebody at the company.

Chris - So you'll need to talk to somebody like a controller or a chief financial officer, administrator, or something, treasurer that some verses like that, that will have documentation about how the articles of incorporation, et cetera were filed so that the company qualifies under qualified small business stock.

Rich - When you actually were issued the stock, right, that's going to be really important in terms of those caps that I talked about. That 75, 50, and 100% cap.

Chris - Okay, got it, got it. One thing you didn't talk about, Rich, but I think it started to pop up is that you didn't spend any time on defined benefit plans? Are those just dinosaurs? Are there some cases where it may make some sense for, say, a business owner to consider that?

Rich - Yeah, that's another great question. I'm not a defined benefit expert, but I do know that it's a different form of retirement plan. So with your 401ks, it's a defined contribution plan where you, the employee, is contributing and maybe your employer is. With the defined benefit plan, the employer is contributing to this. And they're setting a formula in place where at your retirement you're given a certain amount of money, X or Y or Z. And they have to fund that. The employer has to fund that so-called liability, your pension income, if you will. And so based upon the formula, it could mean that the company is socking away hundreds of thousands of dollars on a regular basis and that's going to accumulate in a very tax efficient manner and then paid out. So it's definitely something available to small business owners. I don't see it a ton, but it's definitely something to consider.

Chris - Okay, got it. All right, back to the 83b and I. So these are really intense here. So if you can talk a little bit about maybe the tradeoffs. Are there rules of thumb on when to make the election or when not? And I know you said at the beginning of the presentation, a lot of it depends, you have to make some guesses about the future, there are some tradeoffs, but are there any rules of thumbs as kind of it makes sense to do it when, or it makes sense not to do it when this, are there anything like that you could provide as generalized guidance?

Rich - Yeah, that's a really tricky question, Chris, because I've seen it work very well and I've seen it work not so well. You only have a certain time period to make the election. There's a 30-day window where you have. So if you're going to do it, you have to make a really quick decision. You should know well beforehand, before you even get the shares.

Chris - Don't get to the window in the side. You better have some--

Rich - Yeah, you better say, all right, you know what? I'm expecting this. I'm expecting to get this grant. I'm going to have to pay the tax. If it's a dollar value or $2 per share or $5 per share, you really want to know that tax liability. And there really is no, I wouldn't say there is a rule of thumb. It is how bullish are you on what you're receiving, really. If you're really, really bullish, you're really bullish, tax me now, tax me today, 40 cents on the dollar and I know it's going to IPO at 10 bucks, or maybe worth 20 or the next Facebook or Amazon then.

Chris - It's a good point. There's a lot of specifics to a client's situation. There's a lot of specifics to confidence and other things. So I think that's a good answer. You go in prepared to whatever the decision is. Don't decide on the day.

Rich - Yeah, yeah. Don't wait for your 30-day window.

Chris - Okay, we're getting close to our hour time, but I do want to get some questions in around estate. So kind of estate inheritance, et cetera. So is there other critical issues to consider around the taxation of an estate inheritance, et cetera? So like an inherited IRA, for example, or the transfer of assets from one generation to another. I know they're slightly different topics, but maybe you can touch on those issues.

Rich - Yeah, with the SECURE Act, that really dampened, dampened the ability to really stretch those IRA payments out over a beneficiary's life expectancy. It doesn't apply to spouses, so nowadays that's going to be harder and harder to do when it's, that IRA is going to be passed down to children, for example. They're going to have to take it out within a 10-year window and accelerate that. There are concepts called conduit trusts and accumulation trust. That could be, that are not necessarily going to help the tax situation, but are going to help manage the inheritance for the heirs, the children in particular, when thinking about that. You know, on the estate tax side, I stressed, before I stressed the idea of making sure you have your plans in order today, if you want to pull the trigger on certain estate planning strategies, not just about intrafamily loans, if you want to utilize your exemption for a spousal lifetime access trusts come to mind or grantor retained annuity trusts come to mind, there's a whole host of strategies that one can consider that some or all of the exemption amount or parts of it, but you really have to go into that conversation knowing, "Hey, I'm willing to give away X or Y or Z "before pulling the trigger."

Chris - Okay.

Rich - I hope that answers your question or that question in particular or if it was--

Chris - Well, it was more related to kind of inherited IRAs kind of thinking about distribution schedules, et cetera, which kind of relates to another question, which is with required minimum distribution schedules changing, is there anything to consider around that for, say, somebody who may be receiving them now?

Rich - Yeah, so there was a little holiday under the CARES Act 2020. So everybody got a reprieve, which is great. So the RMD Day was pushed back to 72, which, for some, that's great as well. You get a few extra years of deferral. But like I said, this is sort of the SECURE Act, the put the kibosh on, really extending it out over a beneficiary's lifetime. And it goes back to what I was saying in the beginning, the longer you can defer, I think the better off you're going to be. Tax rates are going to fluctuate as we all know up and down, right? They were 39.6 in the past, at some point. Yeah, they lowered to 37. They could go higher. They could go lower. You know, I don't know where tax rates are going to go. But the longer you can defer, the better. But the SECURE Act put a damper on that for IRAs.

Chris - Yep, yep. Well, I think you made a good point at the beginning. The idea that you panic sell everything now because for certain taxes are going up next year. A, the future is unknowable and uncertain; B, there could be a number of other factors, which you laid out a few early in the presentation, before making those debt decision that you might want to consider. Okay, I think we have time for one more question. We're just getting to the bottom of the half hour here. And I think it's an optimistic one. What advice would you give, Rich, to someone who's younger, starting out about building wealth over time? Besides save everything you can, because that's not always possible.

Rich - Yeah. So start small. Start small, but do it on a consistent basis, all right? And do it now. And start now, even if it is small. Don't wait 10 years, five years, I'll do it tomorrow. And secondly, make it automatic. I can't stress that enough. With direct deposits, ACHs, I mean, you can link everything up digitally and just set it and just completely forget about it, even if it's a very small amount. So start small and you'll find yourself wanting to increase it. You know, it is a little game that folks will play themselves where, All right, I've saved this much. I'm tucking away $50 a week, and now let's make it 51 or 52. So start small, do it sooner, and just forget about it for a long period of time.

Chris - I like that. Never too late to start. Max out what you can, as long as it doesn't impair your lifestyle. Okay, all right. Well, that brings us just about on time here. So first things first, Rich, thank you very much. Outstanding presentation. And I think there's a lot to be digested here. So very much appreciate your thought leadership and guidance. Second, for our clients that have participated today, thank you very much. We very much appreciate your feedback. The questions that came in were amazing. And don't worry if we didn't get to all of them. We'll develop some FAQs and a follow-up so that this forum we can actually have conversations, you can have conversations with your wealth manager. With that, we'll bring our call to a close today. I'm Chris Wolfe, the Chief Investment Officer for our private wealth business. This has been the second in our series of our fall forum. There's a couple more coming and we look forward to seeing your participation there. Thank you, everybody.

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