With interest rates rising (and expected to rise more), it’s important to understand the effects on your retirement and estate.
In our last issue, we reviewed three major estate planning strategies affected by rate changes. Here’s a look at some additional techniques that are worth checking out…
Charitable Lead Annuity Trust (CLAT)
The CLAT is sort of the opposite of the charitable remainder trusts.
It generates more benefits when interest rates are lower.
In the CLAT, you create an irrevocable trust and fund it. The trust pays fixed annual income to a charity for a period of years.
After the period ends, the assets that remain in the trust are transferred to a beneficiary you named. It could be you, your spouse, a child, or a grandchild.
You might receive a charitable contribution deduction for the charity’s stream of income from the trust, depending on the details of how the trust is structured.
If the remainder beneficiary is someone other than you and your spouse, the present value of the remainder interest is a gift from you.
If the trust earns more than the IRS minimum interest rate, the excess will pass to the beneficiary free of estate or gift taxes.
So, a lower IRS interest rate means better results for you and your beneficiary.
Also, the lower the IRS interest rate the higher the charitable contribution deduction.
Qualified Personal Resident Trust (QPRT)
This trust is used to minimize estate and gift taxes when transferring a residence or vacation home to the next generation. The tax results are better when interest rates are higher.
You transfer the title of the real estate to an irrevocable trust. You reserve the right to use the home as your own for a period of years.
After that period expires, the property belongs to the beneficiaries of the trust, who usually are your children or grandchildren.
If you want to continue using the property, you’ll have to pay a fair market rent. That’s why it’s best to use the QPRT for a second home, not your principal residence.
The property will be out of your estate after the term of years ends.
When the property is transferred to the trust, you’ll be treated as making a gift of the property’s present value when the trust terminates to the beneficiaries.
The higher current interest rates are, the lower that value will be.
So, you’ll either use less of your lifetime estate and gift tax exclusion, or pay less in gift taxes as rates rise.
If you pass away before the trust term ends, the property will be included in your estate and treated as though the trust wasn’t created.
Charitable Gift Annuities
In a charitable gift annuity, you transfer money or property to a charity in return for a promise that you will be paid a fixed annual income for the rest of your life.
The annuity payments will be less than from a commercial annuity, and the difference is your gift to the charity.
There’s a tradeoff with charitable annuities, but they probably have more benefits when rates are higher.
There are two tax benefits of the charitable annuity that fluctuate with interest rates.
You receive a charitable contribution deduction when you transfer money or property to the charity. The deduction is the present value of the charity’s eventual gift.
The second benefit is that, when the charity makes payments to you, part of each payment is tax-free as a return of your principal. The rest of each payment is taxable income.
The main benefit is the charitable contribution deduction, and it is greater when interest rates are higher.
Lower interest rates at the time the annuity is created, however, increase the tax-free portion of each annuity payment.
Long-term Property Sales
There are several estate planning strategies used to transfer property to the next generation while minimizing estate and gift taxes.
They are installment sales, private annuities and self-canceling installment notes.
They usually are used to transfer interests in businesses or real estate from parents to their children or later generations.
What they have in common is the estate tax planning benefits are greater if they are implemented when interest rates are low.
Generally, under these strategies, the parents sell the property to the younger generation by transferring the property in return for promises from the younger generation to make payments to the parents over time.
Each of the strategies has detailed rules that must be followed, and there are different situations in which each is more appropriate. If you have a business or valuable real estate, talk to an estate planner about the options.
The IRS Interest Rates
The IRS sets official interest rates each month based on market interest rates for the U.S. Treasury debt.
These are the rates that are used for estate planning and charitable giving strategies. The rates in effect for the month you execute a transaction are the ones you’ll use.
To find the latest rates, search on the IRS website (or any Internet search engine) for “adjusted applicable federal rates.”
It’s also helpful to enter the month and year you are looking for. The IRS issues these rates each month; be sure you use the rates for the right month.
The latest rates usually are issued the second week of each month. There are short-term, mid-term and long-term rates. Consult an estate planning attorney to know which rates to use for your strategies.