Estate Planning Strategies in a Higher Interest Rate Environment

For most people, an estate plan’s primary goal is to help ensure assets go to the intended beneficiaries in a manner that lessens the burden imposed on their heirs.

For many, there is also the goal of reducing taxes. When this is the case, interest rates can play an important role. Therefore, it is important to have a general understanding of how interest rates impact common estate planning strategies. It is also worthwhile to recognize tactics that are most effective in a low-interest rate environment and those that are best when interest rates are higher.

Although interest rates have been at historically low levels since 2010, they have begun to rise. Each month the Internal Revenue Service publishes two important rates that impact certain estate planning techniques: the Applicable Federal Rates (AFRs) and the Section 7520 rate. The AFR reflects the minimum interest rate that must be charged for loans between related parties to avoid a gift tax and the Sect. 7520 rate is used to calculate annual payments that must be made to the beneficial parties when utilizing various techniques. These rates are calculated based on the yields of government debt instruments and the target federal funds rate.

Low-Interest-Rate Environment

Estate Planning in a low-interest-rate environment typically includes utilizing techniques that transfer wealth to family members with little or no gift tax being owed. These strategies often involve senior family members either lending younger family members money, selling them assets, or creating a trust. Applying these techniques provides a predetermined income stream, all in anticipation of the assets being utilized earning a higher rate of return than the applicable prevailing rate. When implemented properly, this technique allows the senior family member to “freeze” the value of the assets being utilized and pass the appreciation on to junior family members (outright or in a trust) for their benefit. Examples of techniques that benefit from a low-interest rate environment are Intrafamily loans, Grantor Retained Annuity Trusts (GRAT), and Intentionally Defective Grantor Trusts (IDGT). Charitable Lead Trusts (CLT) are a technique that benefits those that are charitably inclined. 

High-Interest-Rate Environment

Estate Planning in a higher-interest-rate environment entails reducing the actuarial value of a future gift that would otherwise be taxable. The higher the prevailing rate, the more beneficial these strategies will be. Qualified Personal Residence Trusts (QPRT) and Charitable Remainder Trusts (CRT) are two common techniques.

• Qualified Personal Resident Trust: With a QPRT, a trust is formed to own a personal or vacation residence with the goal of transferring the residence to the trust beneficiaries when the trust term expires. During the trust term, the grantor can occupy the home as they would otherwise, and at the end of the term, they can either give up use or rent the home back. Since the initial transfer is a taxable gift of the remainder interest, the higher the interest rate, the higher the value of the retained right to utilize the property during the term of the trust, and the lower the value of the gift.

• Charitable Remainder Trust: For those that are charitably inclined, when a CRT is formed, a non-charitable beneficiary (typically the grantor or grantor’s spouse) receives a predetermined annual payment from the trust. Either for their lifetime, for a term of up to 20 years, or the shorter or longer of the two. Charity then receives the remainder of the trust value at the end of the specified term. The annual payment that is received is typically a percentage of the trust value, which must be at least 5% and not more than 50%, and the value going to charity must be at least 10% of the trust’s initial value. In a higher interest rate environment, it is easier for the trust to pass the strict IRS guidelines, and at the same time, it gives the grantor a higher charitable income and gift tax deduction.

With interest rates on the rise and uncertainty as to how high rates will go before stabilizing or possibly coming back down, implementation of any estate planning technique that is interest-rate sensitive requires guidance from a qualified estate planning expert. Your BDF team can assist you in better understanding these options and can work closely with you and your estate planning attorney to help implement the strategies that align best with your personal and family goals.