The Wealth Counselor
Low Interest Rate Strategies You Should Be Discussing with Your Clients
COVID-19 has deeply impacted the economy in the United States and will likely continue to do so for some time. While most would agree that this pandemic is not a positive development, there are nevertheless some silver linings. One such silver lining is the significant drop in the federal funds rates. Many experts predict that these historically low rates will remain low for a while as the economy recovers. With such low rates, certain powerful estate planning strategies have become much more attractive and feasible. The following planning strategies are a few that warrant renewed consideration for affluent clients with potentially taxable estates.
1. A Grantor Retained Annuity Trust (GRAT) is a tool that can be created by an experienced estate planning attorney to help a client transfer significant wealth at reduced transfer tax cost. This strategy requires a grantor (the person creating the trust) to transfer property into a carefully drafted irrevocable trust. The trust is designed to pay the grantor a stream of income at least annually and over a specific term of years. At the end of the specified term, the payments end and any money or property left in the trust not already paid to the grantor is transferred tax-free to a remainder beneficiary. This beneficiary is usually a child or descendant of the grantor.
A GRAT is typically structured so that the present value of the annuity payable to the grantor over the specified term of years roughly equals the amount initially transferred to the GRAT. In other words, by using the Internal Revenue Service’s (IRS) published rate of return (the Section 7520 rate) as the assumed rate of growth on the assets, the present value of the annuity payment back to the grantor over the term of the GRAT is designed to be close, if not exactly the same, as the value of the gifted assets at the creation of the trust. The goal, however, is for the actual rate of return on the accounts or property placed into the trust to ultimately be well above the locked-in Section 7520 rate. If this occurs, the assets remaining in the GRAT are transferred to the remainder beneficiaries free of gift taxes.
The following factors can impact the effectiveness of a GRAT:
2. A Charitable Lead Trust (CLT) can also offer significant tax savings for those clients who intend to make charitable giving a part of their estate plan. This is particularly true in today’s low interest rate environment. Similar to a GRAT, a CLT is an irrevocable trust that makes payments out of the trust to a beneficiary over a specified period and is tied to the IRS Section 7520 rate. The period can be a set number of years or for the lifetime of the grantor. Unlike a GRAT, however, a CLT names a charity as the payee of the annuity or unitrust amount over the trust term. Upon completion of the trust term and payments, the assets remaining in the trust pass to the grantor’s chosen beneficiaries, free of gift and estate tax. The value of the gift reported on the grantor’s gift tax return for the year in which the gift was made is calculated as the difference between the amount of the initial gift and the present interest of the annuity or unitrust amount payable to the charity. Because the present interest value is calculated using the currently low Section 7520 rate, the aim is for the assets in the CLT to grow at a higher rate, allowing more of the growth of the assets to be transferred tax-free to the remainder beneficiaries at the end of the trust term. In addition, a CLT can provide valuable income tax deductions to the grantor depending upon how it is structured.
It is important to remember that the payments to the charity must be made each year regardless of the performance of the trust assets. Poor performance can result in a need to distribute trust principle to cover the required charitable payments.
3. Intrafamily loans are another often overlooked strategy to transfer additional wealth to family members without unnecessarily using up a client’s gift and estate tax exemption amounts. These kinds of loans can be an excellent way to help family members recover from low credit scores or eliminate certain high interest commercial home loans, consumer debt, business loans, or education loans, all while keeping interest payments within the family rather than enriching commercial lenders.
In a low interest rate environment like we have today, a client could loan a family member money using the Applicable Federal Rate (AFR) as the interest rate over the term of the loan. The loaned money could then be invested by the borrower in assets that are likely to grow faster than the AFR built into the loan. The difference between the AFR payable to the lender and the realized rate of growth of the invested loan proceeds would accrue to the benefit of the borrower and outside of the estate of the lender. Thus, the lender can indirectly transfer this growth to family members without the need to report that “transferred” amount as a gift to the IRS.
As a reminder, even though these are intrafamily loans, this does not mean that they can be informal. Such loans must be properly documented with executed promissory notes and, where appropriate, secured as if they were arm’s-length transactions so that the IRS cannot reclassify all or part of the loan as a gift.
Getting the Family Involved
There are several other strategies beyond those mentioned that can be used to help your clients take advantage of historically low interest rates. Now is a great time to discuss these strategies with your clients and help them leverage low interest rates in their estate planning. Doing so can help them maximize their wealth even in these economically challenging times. Further, you can demonstrate to succeeding generations of family members the value that you, as the family’s professional advisor, bring to the table. Give us a call today so we can discuss, in person or virtually, the best ways to utilize these strategies.
1. A Grantor Retained Annuity Trust (GRAT) is a tool that can be created by an experienced estate planning attorney to help a client transfer significant wealth at reduced transfer tax cost. This strategy requires a grantor (the person creating the trust) to transfer property into a carefully drafted irrevocable trust. The trust is designed to pay the grantor a stream of income at least annually and over a specific term of years. At the end of the specified term, the payments end and any money or property left in the trust not already paid to the grantor is transferred tax-free to a remainder beneficiary. This beneficiary is usually a child or descendant of the grantor.
A GRAT is typically structured so that the present value of the annuity payable to the grantor over the specified term of years roughly equals the amount initially transferred to the GRAT. In other words, by using the Internal Revenue Service’s (IRS) published rate of return (the Section 7520 rate) as the assumed rate of growth on the assets, the present value of the annuity payment back to the grantor over the term of the GRAT is designed to be close, if not exactly the same, as the value of the gifted assets at the creation of the trust. The goal, however, is for the actual rate of return on the accounts or property placed into the trust to ultimately be well above the locked-in Section 7520 rate. If this occurs, the assets remaining in the GRAT are transferred to the remainder beneficiaries free of gift taxes.
The following factors can impact the effectiveness of a GRAT:
- The health of the grantor and whether the grantor can be expected to live beyond the GRAT term
- The Section 7520 rate for the month in which the accounts or property are transferred to the GRAT
- The nature of the accounts or property being contributed to the trust and their growth potential
- The remaining lifetime gift tax exclusion amount available to the client
2. A Charitable Lead Trust (CLT) can also offer significant tax savings for those clients who intend to make charitable giving a part of their estate plan. This is particularly true in today’s low interest rate environment. Similar to a GRAT, a CLT is an irrevocable trust that makes payments out of the trust to a beneficiary over a specified period and is tied to the IRS Section 7520 rate. The period can be a set number of years or for the lifetime of the grantor. Unlike a GRAT, however, a CLT names a charity as the payee of the annuity or unitrust amount over the trust term. Upon completion of the trust term and payments, the assets remaining in the trust pass to the grantor’s chosen beneficiaries, free of gift and estate tax. The value of the gift reported on the grantor’s gift tax return for the year in which the gift was made is calculated as the difference between the amount of the initial gift and the present interest of the annuity or unitrust amount payable to the charity. Because the present interest value is calculated using the currently low Section 7520 rate, the aim is for the assets in the CLT to grow at a higher rate, allowing more of the growth of the assets to be transferred tax-free to the remainder beneficiaries at the end of the trust term. In addition, a CLT can provide valuable income tax deductions to the grantor depending upon how it is structured.
It is important to remember that the payments to the charity must be made each year regardless of the performance of the trust assets. Poor performance can result in a need to distribute trust principle to cover the required charitable payments.
3. Intrafamily loans are another often overlooked strategy to transfer additional wealth to family members without unnecessarily using up a client’s gift and estate tax exemption amounts. These kinds of loans can be an excellent way to help family members recover from low credit scores or eliminate certain high interest commercial home loans, consumer debt, business loans, or education loans, all while keeping interest payments within the family rather than enriching commercial lenders.
In a low interest rate environment like we have today, a client could loan a family member money using the Applicable Federal Rate (AFR) as the interest rate over the term of the loan. The loaned money could then be invested by the borrower in assets that are likely to grow faster than the AFR built into the loan. The difference between the AFR payable to the lender and the realized rate of growth of the invested loan proceeds would accrue to the benefit of the borrower and outside of the estate of the lender. Thus, the lender can indirectly transfer this growth to family members without the need to report that “transferred” amount as a gift to the IRS.
As a reminder, even though these are intrafamily loans, this does not mean that they can be informal. Such loans must be properly documented with executed promissory notes and, where appropriate, secured as if they were arm’s-length transactions so that the IRS cannot reclassify all or part of the loan as a gift.
Getting the Family Involved
There are several other strategies beyond those mentioned that can be used to help your clients take advantage of historically low interest rates. Now is a great time to discuss these strategies with your clients and help them leverage low interest rates in their estate planning. Doing so can help them maximize their wealth even in these economically challenging times. Further, you can demonstrate to succeeding generations of family members the value that you, as the family’s professional advisor, bring to the table. Give us a call today so we can discuss, in person or virtually, the best ways to utilize these strategies.
Law Offices of Kimberly Lessing, APLC • 4740 Green River Road, Suite 117-H • Corona, CA 92880 • (951) 279-6626