The Federal Reserve continues to slowly increase the federal funds rate. That is the rate banks charge each other. The federal funds rate has an indirect effect on many other interest rates such as the rate banks charge for loans or the amount banks pay on savings. The rates can impact your estate planning because many of the planning techniques used to transfer wealth are interest rate sensitive.
The IRS publishes each month a table of rates (AFRs or Applicable Federal Rates) required to be used for many different estate and gift transfer transactions.
Charitable remainder annuity trust
A charitable remainder annuity trust can be created by gifting or devising cash or property to an irrevocable trust. The donor or another non-charitable beneficiary retains an annuity from the trust for a specified number of years or life. At the end of the term, a qualified charity receives the remainder. The donor will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to charity. The deduction is calculated in part by using the AFR rate at the time the gift is made. As interest rates increase, the value of the deduction will increase.
Charitable lead trust
Like a charitable remainder trust, a charitable lead trust may be set up during life or at your death under a will or trust transfer. A charity or charities receive a fixed annuity from the trust for the number of years you specify. At the end the trust term, the remaining assets are transferred to the non-charitable beneficiary you select. Usually the beneficiary is a child or grandchild, but can be someone who is not related to you. If the trust is structured to obtain a tax deduction, as interest rates increase, the value of the deduction will decrease.
A more simplistic wealth transfer technique is for parents to make loans to children or trusts for grandchildren. For tax purposes, as long as the loan carries an appropriate interest rate, the loan will not be treated as a gift. Assuming the child or trust can yield a higher rate on the funds than the loan interest rate, the benefit over time inures to their benefit. As interest rates increase, so does the required loan rate. That said, taking advantage of this technique before rates increase is a beneficial strategy.
Grantor retained annuity trust (GRAT)
GRATs are another technique that are more effective in lower-interest-rate environments. The GRAT is created by placing assets into an irrevocable trust and retaining the right to an annuity for a fixed term of years or a life term. When the term ends, the assets remaining in the trust, including appreciation, pass to the remainder beneficiaries. The gift tax value of the transferred assets is determined at the time the trust is created. Generally, the interests are valued according to their actuarial present values using IRS rules. These rules mandate the use of a discount rate based upon the 120 percent AFR mid-term rate for the month in which the trust is created and funded. As interest rates increase the taxable gift value increases.
Self-canceling installment note (SCIN)
Normally on the death of the holder of an installment note, the balance of the obligation at the time of death is included in the holder’s estate. However, if the note contains an appropriate self-cancelling provision, the obligor is under no requirement to make any further payments after the holder’s death, and no balance will be included in the holders estate. The SCIN can be an effective means of transferring property to family members without estate and gift tax consequences. As interest rates increase, the design of the technique becomes less efficient.
Other techniques and strategies, and variations on the techniques reviewed above, exist and should be explored. The impact of the interest rate climate should not be ignored and may enable you to increase the tax and financial benefits of your planning strategy.