Interest rates have reached historic lows since the Federal Reserve continued to maintain its quantitative easing program. Given the current environment, high-net-worth clients may want to explore certain strategies that may benefit from lower rates. At the same time, several estate-planning strategies are negatively affected by low rates.
Advisors may want to discuss the following strategies with high-net-worth clients while the opportunity with low interest rates still exists:
1. Grantor Retained Annuity Trust (GRAT). At the end of the GRAT term, the remainder interest to beneficiaries, which would be free of federal gift and estate taxes, depends on whether the trust assets appreciated in value. The higher the growth of trust assets in excess of the IRS interest rate when the trust was established, the greater the amount left to beneficiaries. For August 2013, the IRS section 7520 rate* is 2.0%. The historically low interest rate represents a low “hurdle” for the growth of trust assets to meet and potentially exceed depending on investment selection and market conditions.
2. Charitable Lead Annuity Trust (CLAT). These trusts typically provide a regular stream of income to a qualified charity for a defined term or lifetime of the donor. At the end of the term, any remainder interest is left to beneficiaries. The funding of the trust typically results in a taxable gift to the donor. The amount of the taxable gift depends on prevailing IRS interest rates. The lower the interest rate, the lower the taxable gift. For example, a gift of $1 million into a CLAT by a husband and wife, both 65 years old, would result in a taxable gift of $152,042 based on the August IRS interest rate of 2.0%. At an interest rate of 4%, for example, the amount of the taxable gift would be $282,244.
3. Installment sales. Families often use installment sales to transfer property from one member to another. This can benefit the buyer by spreading out payments over a number of years while deferring taxes due for the seller. To avoid gift tax consequences, the seller must apply an interest rate on payments based on prevailing IRS interest rates. Payment based on lower interest rates allow wealthier family members, such as parents, to transfer property to children with lower costs to the recipient and lower taxable interest payments to the seller.
Low rates may adversely impact certain strategies
A number of estate planning strategies are adversely affected by low interest rates, such as Charitable Remainder Annuity Trusts (CRATs) and Qualified Personal Residence Trusts (QPRTs). In the case of CRATs, the lower-interest-rate environment may make it more difficult for the trust to generate the amount of income required (5% annually) and will result in a lower charitable tax deduction to the donor. In the case of QPRTs, the lower the prevailing IRS interest rate, the higher the taxable gift from the grantor to beneficiaries.
Because interest rates are expected to increase, advisors should consider having an initial conversation regarding these opportunistic strategies now while rates remain low. Depending on individual circumstances, a more in-depth consultation with an estate-planning professional may be prudent.
*The IRS section 7520 interest rate is reset each month.