Rising Rates – Good for Savings; maybe not your Estate Plan

With US interest rates seemingly on the rise, many will rejoice as the interest on their savings account finally starts to brew something more than the cost of their morning cup of coffee. However, affluent families should take a second look at their estate plan and determine if it’s time to take advantage of some wealth transfer strategies that may work well now and consider other strategies that may work when rates start to climb.

How do interest rates impact estate planning strategies? Some strategies depend on investments earning more than a “hurdle interest rate” so they are more appealing when interest rates are low, while other strategies use current interest rates to help calculate a lump sum value (or series of payments to beneficiaries) which can impact tax deductions and the level of potential taxable gifts to heirs.

What works best when interest rates are low? Grantor Retained Annuity Trusts (GRATs) and Intra family loans.

GRATs are often used to pass assets down to heirs without a large gift tax burden and to lower overall taxable estate.  GRATs are set up for a period of 2 years or more and funded with assets that are expected to increase significantly in value. The grantor (for example, a parent) can receive an income stream from the GRAT, which is partially based on the market interest rate and determined by tax rules. If the assets inside the GRAT outperform the market interest rate, this excess return is passed on to the heirs, gift and estate tax free.

Intra family loans can be used when parents want to lend money to their children to invest or transfer a high potential investment to their children while taking back a promissory note in which the children pay interest.  Investment returns that exceed the cost of interest on the promissory note are a tax-free transfer of wealth to the child. Tax rules dictate the interest that needs to be charged and therefore the lower the interest rates, the less of a hurdle to exceed for this strategy to pay off.

What works best when interest rates are expected to rise? Qualified Personal Residence Trusts (QPRTs) and Charitable Remainder Annuity Trusts (CRATs).

QPRTs are designed to pass a primary residence (or vacation home) to heirs while the grantor (typically a parent) retains the right to occupy the home for a stated number of years. A QPRT “freezes” the value of the property for gift and estate tax purposes upon creation of the trust. When interest rates are higher, the present value for gift value is lower, which can be beneficial for estate tax planning.

 CRATs are used by those that are charitably inclined by placing assets into a trust with one or more charities named as beneficiaries. The grantor/creator of the trust will have the right to an income stream from the trust while alive, as well as receive an income tax deduction when the trust is funded. When interest rates are high, the assumed value of the gift to the charity is larger and therefore a greater income tax deduction is possible.

Although interest rates are only one factor in determining the appropriate estate planning strategy for a family, they are an important factor in understanding and deciding which strategies for passing wealth to your heirs may make sense. Now is the time to revisit your plan to assure that the strategies you have in place align with your desires to take care of your family and live a full life.

John D. Smith, CFP® is a Wealth Manager at BDF. A member of the Business Owner Team, he is adept at helping business owners integrate their unique business opportunities and risks into their personal wealth management plan, due to his 20+ years of experience. He finds that business owners, in particular, are often so focused on making sure that their business operations are running smoothly, they may overlook their personal financial well-being. John received his Bachelor of Science degree in Financial Counseling and Planning from Purdue University. He is a member of the Financial Planning Association, sits on the parent advisory board for St Benedict Preparatory School in Chicago, and is a member of the University Club of Chicago.