How Do Interest Rates Impact Your Estate Plan?

Just as rising interest rates influence your investment portfolio, they also factor into estate planning. For high-net-worth families concerned about estate taxes, irrevocable trusts can provide some relief. Depending on the type of trust however, its efficacy can be significantly affected by the applicable federal rate (AFR) set by the IRS, which is in turn dependent on the Federal Reserve’s interest rate policy.

It can get confusing. Let us help provide some clarity, starting with a review of how you might use different trusts and the impact of interest rates on each type.

Grantor Retained Annuity Trusts (GRATs)

Grantor retained annuity trusts have several attractive features, including the ability to:

• Direct assets into an irrevocable trust and freeze their value
• Pass additional growth of assets in the trust on to your beneficiaries
• Reduce estate taxes

A GRAT’s effectiveness depends on interest rates. If the assets transferred to the GRAT grow at a rate that exceeds the AFR, the excess appreciation is transferred to the remainder beneficiaries (like your children) gift-tax-free.

In the past, a GRAT had to beat a much lower interest-rate hurdle to allow additional estate growth to be shifted to beneficiaries. But with the AFR currently ranging from 4% to 5%, the assets in the trust have a higher threshold to beat before those gains can be passed on.

When rates were low, one strategy would be to seed multiple GRATs with high-growth-potential assets in the hopes they quickly realized gains. If the asset declined in value, heirs were unaffected, and you could try again with a new GRAT—essentially a trial-and-error approach to giving your heirs the right to risk-free and gift tax-free investment profits.

Now that rates are at generational highs, GRATs may be a less effective option if you’re prioritizing growing assets in the trust.

Qualified Personal Residence Trusts (QPRTs) 

A qualified personal residence trust allows you to:

• Pass a home to the next generation during your lifetime
• Reduce taxes
• Remain in the home for a chosen period of time, after which the residence becomes the property of your appointed beneficiaries.

The initial transfer of the property to the trust is considered a taxable gift. The value of that gift is determined by the value of the grantor’s remainder interest (their right to use and enjoy the residence during the term of the trust).

When interest rates are relatively high, that remainder interest also increases. The result? A lower taxable gift. That makes the QPRT strategy more attractive when rates are elevated.

Charitable Remainder Trusts (CRTs)

It’s a similar story for charitable remainder trusts. A CRT is an irrevocable trust that can help you accomplish several goals at once:

• Reduce your taxable assets
• Create a predefined income stream for yourself or your beneficiaries
• Make a gift to a charitable organization in the future

When you transfer cash or other assets into a CRT, you receive an immediate income tax charitable deduction based on the present value of the portion of the trust that will ultimately go to the named charity.

The value of the remainder that goes to charity is calculated using interest rates when the trust is initially funded. The higher interest rates are, the higher the value of the remainder interest and the greater the immediate tax deduction when funding the trust. That makes it easier for the CRT to pass IRS muster.

Additionally, a CRT generates income for the grantor. High interest rates make funding that minimum required payment an easier task.

Intentionally Defective Grantor Trusts (IDGTs)

Intentionally defective grantor trusts (strange name aside) are a popular choice for high-net-worth families. This is because they enable you to:

• Pass income-producing assets to your heirs (via limited partnerships, real estate, S-corporation stock or even a family business)
• Lower the tax burden of the gift
• Use income generated within the trust to cover its required interest payments

The sale of an asset to the IDGT is made in exchange for a promissory note that pays back the grantor over time, followed by a balloon payment of the principal. Meanwhile, the grantor of the trust is required to pay the trust’s interest—this could be covered by income generated by assets within the trust or in gifting the necessary cash to the trust—that’s why income-producing assets work best in IDGTs.

When interest rates were low, the size of required payments stayed down and, in theory, you could fund those interest payments with the business’ profits from within the trust without any additional gifting.

Since interest rates are much higher, new IDGTs will require some extra planning. The grantor must have cash flow to pay the income tax of the trust and inject it with cash (if necessary) to cover the promissory note interest payments.

If the asset placed inside the trust does not appreciate faster than the interest rate applicable to the transaction, you lose the benefit of an IDGT.