Planning in a Low Interest Rate Environment
With interest rates near historical lows, we spoke with Chris
Perry, senior fiduciary officer at Northern Trust in Boston,
about the opportunities this environment presents for families
who are planning a wealth transfer.
Q: What is a low interest rate environment?
Each month the Internal Revenue Service
(IRS) announces the interest rate used to
measure the present value of annuities, income
interests and remainder interests for gift tax purposes.
That interest rate is known as the “Section
7520 rate,” and is named after the section of
the Internal Revenue Code that defines it. The
Section 7520 rate now is near its historic low.
In June 1989, the Section 7520 rate was at a
historical high of 11.6%; in July 2003 it was at a
historical low of 3%. In May 2008, it was back at
3.2%. And in September 2008, it was at 4.2%.
Q: How does the low Section 7520 rate affect wealth transfer planning?
For certain estate planning vehicles, a low
Section 7520 rate provides opportunities for
transferring wealth to the next generation in
a tax-efficient manner. One such vehicle is
called a grantor retained annuity trust (GRAT).
A GRAT is an irrevocable trust that pays the
grantor an annuity for a term of years. The
annuity is a percentage of the initial market
value of the GRAT property and is paid out
over the GRAT’s term. If the GRAT is zeroedout
— meaning the present value of the annuity
equals the value of the GRAT property —
funding the GRAT would have little or no gift
tax consequence. If the Section 7520 rate is
low, the total annual investment return of the
GRAT assets could exceed the Section 7520 rate,
in which case the excess property left in the
GRAT at the end of the trust’s term will pass to
heirs or trusts for their benefit.
Let’s say you established a two-year GRAT
in September 2008, and funded it with $10
million. For this example, we’ll assume the
annualized rate of return of the assets in the
GRAT over the next two years will be 9%. In
September, the Section 7520 rate was 4.2%,
which means the GRAT will pay you a total
of $10,634,334 over two years. But because
the assets in the GRAT will be appreciating at
a rate of 9%, you still will have $768,121 left
in the GRAT at the end of the two-year term.
In September 2010, this remainder interest can
pass to your heirs free from gift tax.
Q: Does using a GRAT have any disadvantages or risks?
For someone focused on passing wealth to
the next generation and minimizing overall
transfer taxes, the GRAT has very few downsides.
If the assets in the GRAT don’t appreciate
more than the Section 7520 rate, the annuity
would pay back all the GRAT’s assets to the
grantor. In this situation, the grantor would have
paid the transaction costs to create the GRAT
and the administrative costs associated with
maintaining it without having passed on anything
to his or her heirs.
The other risk is that the grantor dies during the GRAT’s
term, in which case the GRAT’s assets come back into the
grantor’s estate for estate tax purposes.
Q: When would a GRAT be most appropriate?
Anyone who wants a tax-efficient way to transfer wealth
to the next generation — whether they’re modifying a wealth
transfer plan or just getting started — could benefit from a
GRAT or other wealth transfer vehicles designed to work
effectively in a low interest rate environment. But I’d advise
people to seize the day. We have no guarantee that rates will
stay low. By acting now, you can lock in a low interest rate.
If you wait, you may lose the opportunity.
For someone who is new to the estate planning process, it
is generally advisable to execute a will, a revocable trust and
other related estate planning documents before thinking about
more sophisticated estate planning vehicles such as a GRAT.
Q: How long can we expect the Section 7520 rate to remain low?
Nobody knows. Although the two rates are not linked, the
interest rates issued by the IRS track the movement of the
federal funds rate. As the Federal Reserve increases its rates,
the IRS rates typically increase as well. Because we don’t know
what the Fed is going to do, we can’t accurately predict what
the IRS will do either.
Q: What are some other techniques people can use to take advantage of the low IRS rates?
A charitable lead trust (CLT) is a trust to which a grantor
who has charitable objectives makes an irrevocable gift of
property. The CLT then pays the charity a “lead” or income
interest for a set number of years. At the end of the CLT’s
term, anything left in the trust passes to the trust’s remainder
beneficiaries, often the grantor’s heirs. As with a GRAT, the
remainder beneficiaries of a CLT are more likely to receive
assets from the trust when interest rates are low.
Another option is an intra-family loan, in which a parent
loans money to a child in exchange for a promissory note
from the child. The interest rate on the promissory note is
determined by the applicable federal rates (AFRs), which, like
the Section 7520 rate, are published by the IRS. The AFR represents
the minimum interest rate the parent must charge on
the loan in order to avoid having the loan treated as a gift by
the IRS. If the child can take the money and invest it wisely so
that it earns more than the AFR on the loan and ultimately pay
off the note over time, then the child will benefit from any
appreciation that exceeds the AFR.
You might consider an intra-family loan when helping your
child buy a home. But you must remember to collect payments.
If you forgive the debt, you will have made a gift to
your child, and could potentially face gift or income tax
consequences as a result.
Q: Do you have any other advice for people looking at their wealth transfer plans?
As with other financial and investment opportunities, you
should view these kinds of estate planning techniques in the
context of your larger financial picture. Also, remember it isn’t
enough to simply create a trust, put assets into it, and assume
you’re done. You can take advantage of many techniques —
including investment and hedging strategies — to maximize the
upside potential and minimize the possible downside with
these estate planning vehicles. Consulting with your financial
advisor is the best way to explore whether GRATs, CLTs or
intra-family loans are appropriate, and if so, how to increase
the chances that they will be effective at transferring wealth to
the next generation in a tax-effective manner.