How Interest Rates Can Impact the Type of Trust You Use in Your Estate Plan
Rising interest rates are no longer on the horizon; they are slowly becoming a reality. The CPI (Consumer Price Index) hit a 40-year high in January 2022. In early June 2022, reports shared that consumer prices rose at the fastest pace in 40 years during May. In response to this high inflation, the federal government has been incrementally increasing interest rates to slow the economy down. With far-reaching ripple effects felt by families and businesses, rising interest rates also affect estate planning approaches. Now is the time to carefully consider what types of trusts will work most advantageously to preserve your assets and minimize your tax obligations.
The federal government established two interest rates - the Applicable Federal Rate (APR) and Section 7520. These rates are set monthly, and they are based on specific government debt obligations. As interest rates rise, so do the APR and §7520 rates. Both rates affect estate planning strategies and some types of trusts. For example:
- The APR determines the minimum interest rate necessary to prevent gift tax on loans between family members. As the APR rises, the allowable interest rate on family loans increase. This can greatly affect the use of intra-family loans as part of an estate plan.
- The §7520 rate calculates taxable values for specific estate planning strategies. Any fluctuation in this rate can increase or decrease the taxable value, depending on the particular strategy or type of trust.
Estate Planning Strategies for a Low Interest Rate Environment
Typically, the rate that applies to a particular estate planning strategy is the rate in effect at the time the strategy is implemented. As rates change, the efficacy of that planning approach may vary. Some planning strategies are more advantageous in a low-interest-rate environment, while others are more beneficial in a rising rate or higher rate environment.
From 2010 to 2021, rates have remained at historic lows. Even as rates continue to rise in 2022, they remain at a desirable level for wealth transfer purposes. Planning in this environment often includes lending tactics that leverage low interest rates to transfer wealth with little or no gift tax. These strategies typically involve the grantor lending money to a family member(s) to whom they wish to transfer their wealth. The family member would invest the proceeds of this loan with the expectation that the invested proceeds will grow enough to overcome the hurdle, or the low interest rate incorporated in the loan terms, to be a successful transfer of wealth. This technique also allows the grantor, usually a senior family member, to freeze the value of the assets they lend, which would usually be included in their estate for estate tax purposes and pass the asset’s appreciation to younger family members for their benefit.
Here are three effective wealth transfer strategies to take advantage of in a low interest rate environment:
- GRAT – The grantor retained annuity trust (GRAT) is a financial vehicle used to transfer assets to a designated beneficiary that minimizes taxes. Generally used for transferring large financial gifts, the individual utilizing this type of irrevocable trust establishes its gift value at the time the trust is created. Once assets are placed in the GRAT, an annuity is paid out to the grantor every year for a specific term. Once the term expires, the beneficiary receives the assets and pays little or no gift tax.
- CLT – A charitable lead trust is another irrevocable trust that pays a charitable beneficiary an annuity for a set period. A CLT is linked to the interest rate the IRS set in the month it was funded, similar to a GRAT. A CLT may provide a gift, income, or estate tax deduction depending on its structure.
- Intra-family loans – These are loans between family members, such as a parent to a child or grandchild. The lender charges a discounted interest rate reflective of the current AFR set by the IRS.
- Sale to an intentionally defective grantor trust – This is an approach where the grantor sells an asset to the trust in exchange for a promissory note. This trust is created to benefit the grantor’s beneficiaries.
- Self-cancelling installment note – In this strategy, the grantor sells an asset to a buyer in exchange for an installment note that must be paid over a set period of years. The obligation to pay the note ends upon the grantor’s death, even if the loan term has not expired.
Enlist a Trusted Partner to Navigate the Estate Planning Process
BMC Estate Planning attorneys are experts in estate planning law and possess the critical financial acumen to advise clients in wealth transfers during the estate planning process. Our skilled team is well versed in the benefits of using various investment vehicles to safeguard your wealth, minimize taxes, and generate returns. We know that not every client is a savvy investor and will depend on our guidance to ensure that their estate plan is set up appropriately to transfer wealth seamlessly and avoid costly mistakes. Schedule a consultation with BMC Estate Planning and enlist a knowledgeable and trustworthy partner in the careful planning of your estate.
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