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Estate Planning in a Low Interest Rate Environment

April 16, 2021 | By Katharine George, CFP®, AEP®
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Interest rates are at historically low levels, which means right now is an opportune time for you to use certain estate planning strategies. If you have a large estate, you can take advantage of the current low interest rate environment to shrink your future estate-tax liabilities.

In this insight, I’ll go over three classic low interest rate estate planning strategies. 

Who benefits from low interest rates?

Low interest rates can be beneficial to those with estates that exceed federal or state estate tax exemption amounts. The federal government sets interest rates on a monthly basis, to be used for asset transfers. These interest rates are currently at historic lows, providing for opportunities to shift wealth out of an estate and potentially reduce future estate-tax liabilities.

3 Estate Planning Strategies to Use When Interest Rates Are Low

Low interest rates favor certain estate planning strategies. Three classic (and effective) strategies are transferring assets to a grantor retained annuity trust (or GRAT), transferring assets to a charitable lead annuity trust (CLAT), and making “intra-family” loans to family members. Let’s look at each strategy in more detail.

Grantor Retained Annuity Trust (GRAT)

In a GRAT, you (the grantor, or creator of the trust) transfer assets to an irrevocable trust and retain the right to fixed annuity payments for a specified term of years. At the end of the term, your trust’s remaining assets pass to your designated beneficiaries.

GRATs and CLATs use the Federal Government’s Section 7520 rate in calculating how much interest must be paid back to the grantor or charity. A GRAT is successful to the extent that the assets in the trust accumulate above the Section 7520 rate. The lower the 7520 rate, the easier it is to have accumulation above and beyond that rate which transfers to your beneficiaries free of any gift or estate tax. In other words, utilizing a GRAT is highly effective in a low interest rate environment. 

Charitable Lead Annuity Trust (CLAT)

A CLAT is structured the same way as a GRAT, except that a charity retains the right to the fixed annuity payments as opposed to the grantor. At the end of the term, your trust’s remaining assets pass to your designated beneficiaries.

There are additional tax benefits to a CLAT. As the donor, you are allowed to claim a charitable deduction on the amounts passing to charity. Just like with GRATs, investment growth in excess of the Section 7520 rate passes transfer tax-free to your beneficiaries at the end of the trust’s term. The lower the rate, the larger your potential tax-free transfer.

Intra-Family Loans

Intra-family lending is a technique that benefits from low interest rate environments and does not incur gift tax, provided that the loan is structured properly and is clearly documented. You are generally required to charge an adequate interest rate on a loan to a family member, otherwise you may owe gift tax. The IRS established a so-called Applicable Federal Rate (AFR—click the link to see the rate for each month) for these types of loans.

Let’s go through a quick example of how intra-family loans operate. Suppose you gave a $1M loan to your adult son for 10 years at a 1.5% interest rate (based on the AFR at the time) and your son invests the proceeds in an investment earning 5% after taxes. Throughout the life of the loan, your son would pay about $165K in interest, but his investment would grow to about $1.5M net of interest payments. Therefore, roughly $500K is transferred to your son gift-tax free. In this case, any investment costs and taxes would be incurred by your son.

More intra-family lending strategies

Instead of making loans directly to family members, another option would be to make a loan to a grantor trust for their benefit. This would work similarly to the intra-family loan example above, except that the grantor (lender) would pay the taxes incurred on the investments instead of your son.

Intra-family mortgage lending can also be a good way to assist family members without incurring gift tax. In addition to the benefit of a low interest rate, interest payments stay within your family instead of going to a bank.

Another benefit of intra-family lending is that you can also forgive a portion of the loan annually, up to the annual gift tax exclusion amount, without incurring gift taxes.

There are potential drawbacks, though. Lending money between family members can be uncomfortable for either or both parties (the borrower or the lender). And, in certain instances, gift taxes may occur if interest payments are not made. Plus, the borrower is not building their credit history when engaging in this kind of lending.

The strategies mentioned above are a few estate planning opportunities that are more beneficial in a low interest rate environment. Of course, low interest rates do not preclude you from utilizing other strategies. If you are planning to make gifts to a family member or someone else, consult with your financial advisor, tax preparer or estate planner to see what is recommended.

Ready to take the next step with your estate plan? Schedule a complimentary 30-minute consultation with one of our financial planners today!

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