- With federal interest rates relatively low for the time being and rate hikes expected, the current environment may make it attractive for those considering IRS rate-linked strategies as a part of a wealth transfer plan.
- The techniques discussed can be effective if implemented when interest rates are relatively low. Although rates are on the rise, they remain relatively low compared with prior decades. If rates increase, these techniques may not be as attractive. Proposed legislation may also remove some opportunities that are available today.
What this may mean for you:
- If you are considering transferring your assets, evaluate the use of rate-linked strategies to help enhance the transition of your family’s wealth before rules surrounding these potential wealth transfer strategies may be changed.
This update outlines three estate planning strategies to help take advantage of low interest rates and increased estate exemptions. Changes in tax legislation could reduce or eliminate many of the benefits described below. Please consult your estate and tax advisor before proceeding with any of the strategies explained below.
How do interest rates affect estate planning techniques?
Are you planning to transfer any assets in the future?
Each month, the IRS publishes an applicable federal rate (AFR) that can be used for personal intra-family loans, as well as certain related discount rates that may be used for present value computations that apply to a variety of estate planning strategies. Both the AFRs and the discount rates can impact the related calculations and the effectiveness of the strategies. Three wealth transfer techniques — grantor retained annuity trusts (GRATs), charitable lead trusts (CLTs), and loan-based solutions — can be more effective when rates are low.
In a low interest rate environment, investors have a low hurdle rate to overcome in order to transfer surplus wealth to their beneficiaries. If markets are favorable and you achieve a total return greater than the hurdle rate over the term of the trust, the value transferred to the beneficiaries could be greater than the amount initially transferred and reported as a gift.
Additionally, the low AFRs may allow you to act as a lender and charge a lower interest rate to your beneficiaries to transfer wealth at a more efficient rate. A rise in federal interest rates will increase the linked IRS hurdle and intra-family lending rates, making GRATs, CLTs, and intra-family loans less advantageous. In 2022, the rates have risen slightly, but the interest rates are still at a very desirable level for wealth transfer purposes.
Three wealth transfer strategies to help take advantage of the low rate environment:
- GRAT: A GRAT is a wealth transfer technique commonly used to transfer assets to a designated beneficiary. This strategy is typically considered successful when the assets placed in a GRAT appreciate at a rate that exceeds the discount rate over the term of the GRAT.
- CLT: A CLT is an irrevocable trust that pays a charitable beneficiary an annuity or unitrust amount for a prescribed period of time. Similar to a GRAT, a CLT is linked to the interest rate the IRS set in the month it was funded. Depending on how it was structured, a CLT may provide an income, gift, or estate tax deduction.
- Loan-based solutions: Low interest rate environments may be advantageous for personal, intra-family loan-based solutions where you, as the lender, can provide your beneficiaries with loans at the prescribed AFR, which often may be below commercial rates.
- Intra-family loans: These are loans between family members, often a parent to a child or a grandparent to a grandchild, in which the lender charges interest at the prescribed AFR set by the IRS.
- Sale to an intentionally defective grantor trust: This is a strategy in which a “grantor” trust is created for the benefit of the seller’s heirs. The seller sells an asset to the trust in exchange for a promissory note.
- Self-canceling installment note: This is a technique in which the seller sells an asset to a buyer in exchange for an installment note that is to be paid over a term of years. What makes this technique special is that the buyer’s obligation to pay the note automatically ceases upon the seller’s death, even if the term of the loan has not yet expired.
With interest rates at historical lows for the past few years and a prediction of steady increases on the horizon, this could be a good time for families with estate tax exposure to evaluate estate planning strategies that benefit from favorable AFR and Section 7520 rates, which are still not far above historic lows. We suggest speaking with your advisor, as well as your tax and legal advisors, about what is most appropriate for your individual and family situation. Please be aware that proposed tax legislation could alter or eliminate many of the benefits described above.
Wells Fargo and Company and its Affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.
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