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How Low Interest Rates Can Boost Your Estate Planning

Last update on: Aug 10 2020
estate planning

Low interest rates and depressed stock prices are making a classic Estate Planning strategy significantly more attractive. People who could benefit from the estate planning strategy should look into it before interest rates rise.

This tool has the un-sexy name of grantor retained annuity trust, or GRAT. It has the sexy result of allowing you to pass wealth to the next generation free of gift and estate taxes. This tax-free gift does not count against the annual $11,000 tax free gift exclusion or the lifetime estate and gift tax credit.

Here’s how the GRAT works. You put an asset into a trust and set the term the trust will last. Let’s say you set the term at two years. The IRS has a minimum annuity interest rate factor, and to get the maximum tax benefit you use that rate. For March it was 3.89%, and it is set monthly. After the first year of the two-year trust, you receive a payment equal to one half the original principal plus compounded 3.89% interest. After the second year, you receive the same payment. The distributions can be paid in cash or property. You pay income taxes on the interest portion of each payment.

Here’s where the real benefit comes in. The trust, and eventually its beneficiaries, gets to keep whatever appreciation and income exceeds the annuity interest rate. If the rate is 3.89% and the property appreciates eight percent, then your heirs get to keep 4.11%. There are no gift or estate taxes paid on this money.

Suppose Max Profits has $1 million of stock. He puts this into a GRAT that will pay him an annuity at the 3.89% rate for two years. Whatever is left in the trust goes to Max’s children. After the first year, Max receives a distribution of $529,361. He receives the same amount after the second year. Max’s timing was good, and the stock appreciates a total of $75,000 above the payments to him. Max’s children get to keep that $75,000, with no income, estate, or gift taxes due.

Now is the ideal time to set up a GRAT because of the combination of low interest rates and depressed stock prices. The low rates minimize the amount that has to be paid to Max and increase the potential tax-free transfer to Max’s children. The depressed stock prices increase the chances that the stock will appreciate enough to provide a significant amount to the children.

Many types of assets can be put into a GRAT.

Small business interests are an ideal choice. When a less-than-controlling interest is put in the trust, a substantial discount from the stock’s value is allowed when valuing the stock. You need a business appraiser to determine the value of the stock both at the beginning and end of the trust. Another reason small business stock is a good choice is that the appraiser will consider factors other than the stock market when determining the appreciation, and that increases the probability the stock will outperform the annuity interest rate.

Stock options also can be good choices for a GRAT if they are non-qualified, vested, and transferable.
Stocks and mutual funds can be included in a GRAT, and are good choices if you are optimistic that their returns will exceed the IRS interest rate over the term of the trust. Real estate also is appropriate for a GRAT.

A GRAT term typically is two to 15 years, with most GRATs believed to be in the two to five year range. The trust term is important. If you, the grantor, do not outlive the trust term then all of the trust property is included in your estate. The result is the same as if you never had set up the trust, except that you are out of the cost of creating the trust. So, it is important to set the trust term for a period you are likely to outlive.

Another risk of the GRAT is that the property might not appreciate beyond the IRS rate or might decline in value. In that case, the heirs get nothing from the trust and you are out the cost of creating the trust.

You want to put into the trust only property that exceeds what you need to meet living expenses and property you won’t need the appreciation from. If the appreciation would be important to your lifestyle, look for other property to put in the trust.

Of course, you shouldn’t consider a GRAT unless your estate exceeds the tax free amount of $1 million, $2 million if you are married ($1.5 million and $3 million in 2004), and you should put in the trust only the part of your estate that exceeds these amounts. In addition, you have to consider the cost of setting up the trust. It can be $1,000 and up, depending on where you live and whether an appraisal is needed. There also will be cost of maintaining the trust each year, which also varies based on where you live. Because of the costs, estate planning professionals believe the minimum that should be put in a GRAT is $400,000, and some estate planning advisors put the minimum at $2 million.

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