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By Jeffrey R. Wolfe, Senior Vice President, Manager of Wealth Planning Strategies

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Interest rates have become a hot topic these days.  Many people complain there aren’t any bonds paying a good enough rate.  Meanwhile, President Trump complains that the Fed’s interest rates are too high.  Credit card rates, home mortgage rates, you name it, and interest rates are everywhere.

While not often top of mind, there are also interest rate issues in the estate planning world.  In particular, there is a government provided interest rate, commonly called the 7520 rate[1], that many planners follow diligently.   And right now, the 7520 rate is historically low (1.8% for this month), meaning that in the right circumstances there is no time like the present to consider certain estate planning techniques.

A perfect example of how a low 7520 rate may be beneficial is a Grantor Retained Annuity Trust (“GRAT”).  A GRAT is a federally recognized trust arrangement where the grantor/creator of the trust transfers assets to the trust. The trust terms provide that the grantor retains an annuity payment back from the trust of some identified value, and for a term of years (2, 4, 10 years, whatever is decided). At the end of the trust term, after the full annuity payments have been made to the grantor, any remaining assets in the GRAT pass to the named trust beneficiaries. In short, a pretty simple set of guidelines.

The reason a low 7520 rate is important is the math of the GRAT.  The 7520 rate is used to determine the present value of the future remainder of the trust, somewhat similar to an assumed rate of return. Let’s consider an example. Assume the grantor puts $100,000 worth of assets into the GRAT. Let’s also assume the grantor retained an annuity stream that has a present value of $90,000. This calculation leaves us with $10,000 remaining for the GRAT beneficiaries. Consequently, the grantor will have made a $10,000 gift and will have to pay gift tax (or apply the lifetime exclusion amount, currently $11.4 million) on a properly filed federal gift tax return (Form 709) when creating this GRAT.

The magic happens when the contributed assets appreciate greater than the 7520 rate.  Let’s assume after the GRAT term ends instead of $10,000 in the trust there is $30,000.  Since the tax is calculated and “paid” at the beginning of the GRAT term, the trust beneficiaries receive $30,000 worth of assets for only a $10,000 gift tax consequence in this example. In essence, the grantor has “frozen” the value of the gift for gift tax purposes at $10,000, and any growth in excess can pass gift tax-free. However, there is risk in this transaction.[2] If the GRAT performs worse than expected, you may suffer a tax loss so to speak. Assume at the end of the GRAT only $5,000 remained. In that example the grantor paid $10,000 in gift tax only to actually transfer $5,000.

GRATs aren’t the only type of planning that may benefit from a low interest environment.  Charitable Lead Trusts “CLTs” (where assets are first left to a charity, typically for a term of years, and then allowed to pass to beneficiaries) or Qualified Personal Residence Trusts (“QPRTs”, where real estate may be left in a trust with the owner utilizing the property for a term of years and then the property passes to beneficiaries), use similar calculations to determine the value of a present interest gift for beneficiaries.  For any of these plans, the ideal assets would be something that is expected to grow in value significantly faster than the 7520 rate and/or assets that generate significant income.

While we’ve only scratched the surface of these planning techniques and the complexities associated with them, the point is that if you are looking to transfer assets in a tax efficient manner, now may be one of the most opportune times in recent history.  Low interest rates, along with the highest estate tax exclusion in history (currently $11.4 million per person), means that the time to consider planning is now.  Work with your Benjamin F. Edwards financial advisor, along with your tax and legal counsel, to determine whether you should consider some of these planning techniques.  Doing so may lead to a superior after-tax transfer of wealth.

 

IMPORTANT DISCLOSURES

The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards & Co. is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.

[1]  The “7520 rate” is based on IRS Code 7520 which provides an updated rate for each particular month where the rate is 120 percent of the applicable federal midterm rate (compounded annually) for the month in which the valuation date falls.   See IRC 7520.

[2] Other risks for GRATs include that if the grantor dies before the end of the GRAT term, the value of the GRAT is included in the grantor’s estate for estate tax purposes.  There are also the costs to create and administer the GRAT during the term of the trust.  For more, speak with your legal professionals to better understand your particular situation and the benefits and risks associated to your plan.

October 22, 2019 |