When people think of estate planning, they rarely consider how the rise or fall of interest rates can impact their wealth transfer goals. Whether you are just beginning to think about your estate plan, or you have an established plan in place, we’ll explain why you should pay attention to the trend in interest rates.
There are two main interest rates relevant to estate planning: the Applicable Federal Rate (AFR) and the 7520 rate. The short-term, mid-term and long-term AFRs are calculated based on the average interest rate for similar treasury obligations and are published in an IRS revenue ruling every month. The 7520 rate, determined monthly by the IRS, refers to Section 7520 of the Internal Revenue Code and is about 120% of the midterm AFR at the time it is set.
So why do these rates matter to your estate plan? In a low-interest rate environment, you can generally gift more with less income, estate and gift tax ramifications, though there are some exceptions. Interest rates also impact the tax efficiency of certain estate planning strategies and may affect the best timing to establish those strategies. Additionally, the interest rate applicable when a trust is created generally controls throughout the duration of the trust’s term and does not adjust as interest rates spike or drop.
Some common estate planning tools sensitive to interest rates include: loans to family members; grantor retained annuity trusts (GRATs); sales to intentionally defective grantor trusts (IDGTs); qualified personal residence trusts (QPRTs); and some charitable trusts.
A loan to a family member has a greater tax benefit in a low-interest rate environment because the minimum interest required to be paid to the lender is smaller, which allows the family member making the loan to receive less taxable interest income without triggering gift tax or imputed interest.
GRATs and IDGTs also benefit from a low-interest rate environment. With GRATs, the annuity payment the trust is required to pay to the grantor during the GRAT term (the original cost plus a rate of return that assumes appreciation of the asset up to the 7520 rate at the time the trust is established) will be less if interest rates are lower. This, in turn, allows assets held in the GRAT to more easily outpace the 7520 rate as they increase in value, thus transferring more assets out of the grantor’s estate at the end of the GRAT term.
An IDGT is a trust that is disregarded as separate from its grantor for tax purposes. In a low-interest rate environment, a grantor selling assets to an IDGT in exchange for a promissory note (which often requires annual interest payments and a balloon payment at the end of the note’s term) will be able to remove less assets from the trust in the form of annual interest payments, thereby allowing more trust assets to go to the beneficiaries. The benefit provided by low interest rates is greater the longer the term of the promissory note.
On the other hand, QPRTs have a greater estate tax benefit in a high-interest rate environment because the retained value of the residence will be higher, which, in turn, reduces the amount subject to gift tax.
Focusing on fluctuating interest rates also allows us to spotlight one of the most common mistakes people make with their estate plans: they create a plan for their current situation and don’t review it when things change. For example, changes in the lifetime exclusion amount and interest rates can cause your estate plan to become unbalanced. A plan created when the lifetime exclusion was relatively low may now cause more funds to be placed in a credit shelter trust than had originally been intended. And then, of course, life often plays out differently than when we had planned!
Estate plans are not static and should be updated periodically to reflect your current life situation, estate planning goals, and, let’s not forget, interest rates. Call on The Tax Warriors® at Drucker & Scaccetti to help review your existing estate plan or help you create a plan that satisfies your personal goals while being as tax efficient as possible.