It still comes as a surprise to so many retirees…
The outcome of key estate planning strategies often hinges on fluctuations in interest rates.
So, clearly, changes in rates should sway the choice, or timing, of these strategies.
Some estate planning strategies generate more benefits when interest rates are low, while others provide more benefits to you and your loved ones when rates are higher.
With interest rates rising, and set to rise more, you should consider interest rate trends when deciding whether to accelerate or delay the implementation of your estate plan.
Let’s take a look at the major strategies that are affected by rate changes.
Loans between family members typically carry no interest rate or very low interest rates, which is why they’re often called interest-free or low-interest loans.
They are very flexible, simple, and provide a lot of benefits as long as the tax rules are followed. That’s why they’re very popular. This strategy is better when interest rates are low.
One family member lends another money or property, expecting the principal to be repaid at a certain time.
The plan often is for the borrower to generate income or capital gains from the principal and keep those benefits.
Other times, the goal is for the borrower to pay a lower interest rate than a commercial lender would charge, while the lender might earn a higher yield than is available through a safe investment, such as a money market fund.
One way to make a family loan is to charge at least the minimum interest rate required by the tax code. (I’ll share more details about determining the interest rates currently required by the tax code and the IRS later.)
When you do that, there are no special income or gift tax consequences. As loan repayments are made, the interest portion is income to the lender, and the rest of the payment is tax free.
Another way to make the loan is to charge no interest, or less than the IRS minimum rate. In that case, the interest not charged is a gift from the lender to the borrower.
If the interest plus other gifts to the borrower for the year are less than $15,000, there are no real consequences, because that’s the amount of the annual gift tax exclusion.
Any excess over the $15,000 exclusion will reduce the lender’s lifetime estate and gift tax exemption, or will be a taxable gift.
You might be able to make interest-free loans without tax consequences if the loans are less than $10,000.
Also, income and gift taxes could be modest when total loans to a borrower are less than $100,000.
Details of those exceptions are in IRS Publication 550, beginning on page six under the heading “Below-Market Loans.”
Keep in mind that the loan must be a real loan. There should be a written agreement that lists the interest rate charged and a payment schedule. Otherwise, the IRS might treat the transfer as a gift or other transaction.
A grantor retained annuity trust (GRAT) is a good way to transfer the gains from appreciating assets to loved ones. It generates more benefits when interest rates are low.
In a grantor retained annuity trust, you set up an irrevocable trust funded with assets you expect will have a fairly high appreciation rate.
The trust pays you an annuity over a period of years. The total annuity payments equal the original trust principal plus the IRS minimum interest rate.
At the end of the trust term, whatever remains in the trust is transferred to the other beneficiaries after the trust expires, usually your children or grandchildren.
Your loved ones receive the investment return of the trust that exceeds the minimum interest rate, and there are no estate or gift taxes due.
A grantor retained annuity trust usually should be short-term. Most tax advisors say a two to three year trust term is best.
To make incurring the costs of creating the trusts worthwhile, they should be funded with at least $250,000 of assets that are expected to generate a total return well above the IRS minimum interest rate.
If the trust assets don’t earn more than the minimum rate, your heirs won’t receive anything. The result will be the same as if you hadn’t created the trust, minus the fees related to it.
These trusts come in two forms: charitable remainder unitrust (CRUT) and charitable remainder annuity trust (CRAT).
Both of them provide more tax benefits when interest rates are higher.
For either trust, you create an irrevocable trust and fund it with money or property, preferably appreciated long-term capital gains property.
The trust pays you income for life, or a period of years. The charitable remainder unitrust pays you a percentage of the trust’s value each year as income.
The charitable remainder annuity trust pays you a fixed amount each year, regardless of the trust’s value. After the income period, the remaining property in the trust is transferred to charity.
One benefit is you don’t owe capital gains taxes on appreciated property transferred to the trust, because it is a charitable trust.
A second benefit is you receive a charitable contribution deduction when the trust is funded. The deduction is the present value of the property the charity is expected to receive at the end of the trust.
The amount of the deduction depends on how long the trust is expected to last and on the current IRS interest rate.
Suppose a 60-year-old transfers $3 million to a charitable remainder unitrust that will pay him 5% of the trust value annually for life.
If the current IRS interest rate is 1.2%, the charitable contribution deduction is $1,141,560. But if the interest rate is 3%, the charitable contribution deduction is $1,159,080.
In Part 2 next week: long-term property sales, charitable gift annuities, and more estate planning strategies.