Interest rates might not seem relevant to estate planning, but they can be. Some strategies are best implemented when interest rates are relatively low—as they are now, believe it or not—while others may benefit when interest rates are relatively high, which may soon be the case.
If your estate is nearing or exceeds the lifetime gift and estate tax exemption (in 2022, $12.06 million for individuals; $24.12 million for married couples), employing lending and gifting strategies that leverage low interest rates could, over time, help reduce the size of your taxable estate.
Here are three ways to capture today's relatively low rates before they move higher.
1. Intrafamily loans
When making a cash loan to a family member, you're required to charge a minimum interest rate—known as the Applicable Federal Rate (AFR)—based on the loan's length.
However, current rates are still quite low—especially when compared with the potential returns your assets could earn in the market over the long term. If any assets purchased by the borrower with the loan appreciate beyond the interest owed to you, those gains are effectively transferred to your loved one without using the lifetime gift and estate tax exemption.
Just be aware that the loan—which should be structured as a fixed-term, interest-only loan with full repayment of the principal at maturity—must have a written promissory note and require regular payments from the borrower.
If you later forgive the loan, the IRS will consider the forgiven balance as a gift that will count against your lifetime exemption. And if you happen to pass away before your family member has repaid the loan, the value of the promissory note will be included in your estate for estate tax purposes.
2. Grantor retained annuity trust (GRAT)
As the GRAT's creator, or grantor, you transfer assets into a fixed-term, irrevocable trust—meaning that its terms generally cannot be changed, and you must designate a trustee other than yourself. You then receive annuity payments plus a rate of return determined by the IRS' Section 7520 rate at the time of the trust's creation.
If you structure the trust as a "zeroed-out" GRAT, in which your cumulative annuity payments equal the original value of the assets, any appreciation of the assets above and beyond the 7520 rate passes to your beneficiaries tax-free at the end of the term.
A word of caution: A GRAT is considered a "bet to live" strategy. If you pass away before your GRAT term ends, the value of the remaining assets, including earnings, will be included in your taxable estate.
In addition, there's always the possibility that the assets in the GRAT may not perform as expected, potentially negating the wealth transfer at the end of the term.
Because of this, a common approach is to set up a two-year GRAT. Longer terms may be more advantageous, but you should consider your age, health, and other factors when choosing the term of your GRAT. You may incur legal and administrative costs when creating a GRAT.
3. Charitable lead trust (CLT)
A CLT works like a GRAT in that it's also irrevocable and carries the same risks as well as setup and administration costs, but instead of paying an annuity to yourself, you're paying it to a charity. At the end of the trust's term, any remaining assets pass to your chosen beneficiary, which can be yourself or your heirs.
CLTs are slightly more complicated than GRATs due to their tax considerations, which vary depending on how you structure the trust:
- A grantor CLT treats the donor as the owner of the assets for income tax purposes, allowing you to take a charitable tax deduction in the year the trust is funded equal to the present value of the transferred assets. However, as the grantor, you are also responsible for paying income tax on trust income during the term. Because of this, grantor CLTs are better suited to income-tax planning rather than estate-tax planning.
- With a nongrantor CLT, the trust owns the assets, allowing it to take an unlimited charitable tax deduction over its term. Although you as the grantor do not receive a charitable tax deduction for the transferred assets, you are not liable for any taxes during the term, nor is the remainder beneficiary liable for future taxes on the trust assets' appreciation.
The IRS requires that you use actuarial tables to determine the present value of the charitable annuity for tax purposes (download Table B under "Standard Annuity, Income and Remainder Factors").
When you use Table B, the law requires that you apply an interest rate equal to the IRS' Section 7520 rate at the time of the CLT's creation. The lower the Section 7520 rate, the larger the value of the annuity—and the smaller the value of the remainder interest for gift-tax purposes.
For example, let's say you create a 10-year, $10 million CLT that will distribute a $1 million annual annuity. Using the 7520 rate established in January 2022 (1.6%), your present value factor for a 10-year term would be 9.1735. That means your total charitable interest is valued at $9,173,500 ($1 million x 9.1735), whereas the remainder interest—that is, the amount potentially subject to gift taxes—is valued at $826,500.
Structured as a nongrantor CLT, the trust claims a charitable deduction for the annuity payments and pays tax on any income generated from the trust assets. If the assets grow at, say, 7% annually during the term, the remainder interest would be worth $4,610,252 when passed to the noncharitable beneficiary, whereas the value of the assets for gift tax purposes would be just $826,500.
While estate planning may seem like a one-and-done endeavor, the most successful plans are dynamic, adjusting to the needs of you and your family, along with the current environment. Scheduling regular check-ins with your financial advisor can help ensure your plan continues to meet your needs, as well as help you stay ahead of changes in interest rates, exclusion limits, and other outside forces that could impact your estate.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Charles Schwab Trust Company and Charles Schwab & Co., Inc., do not provide legal or tax advice. Consult with your legal counsel and tax advisors about your particular circumstances.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Charles Schwab & Co., Inc. (Schwab), is affiliated with Charles Schwab Trust Company (CSTC), the corporate trustee for Schwab Personal Trust Services (SPTS). Schwab may introduce clients to CSTC but does not evaluate whether SPTS is appropriate for each client or recommend SPTS for any particular client. It is the client's responsibility to ensure that CSTC meets his or her trust needs and to conduct any due diligence that may be required before engaging CSTC.
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