As the Federal Reserve continues fighting inflation with higher interest rates, clients should know that various trusts can be effective wealth-transfer strategies when rates rise—but also that not all trusts are equally effective.
Trusts’ performance as estate planning vehicles are often tied to the federal funds rate, “the ‘7520 hurdle rate’,” said Alexandra Blake, director and wealth advisor at Crestwood Advisors in Darien, Conn. For example, she said, the current AFR for a mid-term grantor retained annuity trust (GRAT) is around 4.6%. “The first 4.6% of the returns of the underlying investments would be returned to the grantor with the amount above the 4.6% passing onto the beneficiary. If investment returns don’t exceed the hurdle rate, the strategy would fail to move assets out of the grantor’s estate,” Blake said.
“It’s important to emphasize that there is a very limited downside to most of these strategies,” Blake added. “Even if the investment return doesn’t beat the hurdle rate, the only sunk cost is the few thousand dollars to set up the initial vehicle.”
A grantor retained annuity trust, a sale to an intentionally defective grantor trust or a charitable lead annuity trust tend to produce greater tax benefits in low interest rate environments, said Alan Weissberger, director and portfolio manager at Hirtle, Callaghan & Co. in Conshohocken, Pa. On the other hand, he said, a number of planning strategies are more effective in higher interest rate environments. “Three of these [are] a qualified personal residence trust, a charitable remainder annuity trust and a charitable gift annuity,” he said.
Different trusts and other vehicles offer different benefits when rates change:
• Grantor retained annuity trust: The grantor retains a right to an annuity for a term of years with the remainder going to various beneficiaries. The value of the remainder is a taxable gift at the time the trust is funded and calculated using the 7520 rate, said Peter Trieu, a partner in Crowe Private Client Tax Services in San Francisco. “A high interest rate equates to greater value assigned to the retained annuity, making the value of the taxable gift lower.” he said. This can reach a “zeroed-out” GRAT.
• Charitable lead trust: “A grantor contributes assets to a trust giving a charity a right to an annuity payment for a term of years; the remainder goes to the grantor and/or other beneficiaries. If passing to other beneficiaries, the remainder is a taxable gift. As with the GRAT,” Trieu said. “The higher the interest rate, the higher the value of the gift to charity, and the lower the taxable gift of the remainder.”
• Qualified personal residence trust: In transfer of a home to a trust, “the donor retains the right to live for a fixed term, after which it passes to the donees,” said David Handler, a Chicago-based partner in the trusts and estates practice group of Kirkland & Ellis LLP. The current 7520 rate is a main factor in the favorable estate tax treatment of valuing the gift of a residence; a QPRT stops the value of the taxpayer’s residence when the trust is created, lowering eventual taxes.
• Charitable retained annuity trust: Allows the grantor a stream of annuity payments for a term of years with the remainder going to charity; the 7520 is used to calculate the value of the remainder interest passing to charity. “A higher interest rate equates to a greater gift to charity, providing a larger income tax deduction,” Trieu said.
• Charitable remainder trust: Not for wealth transfers, but to defer or avoid income taxes and to benefit charity. “The donor contributes assets and receives payments for a term or for life, after which the assets pass to charity,” Handler said. “With higher interest rates, the payments to the donor can be higher.”
With a charitable gift annuity, Weissberger added, a contract between a donor and a charity allows a donor to make a gift to the charity in exchange for a fixed stream of income. The charity invests the CGA assets; at the end of the donor’s life, the charity receives the remainder of the gift. “CGAs provide a larger charitable deduction when interest rates are high,” Weissberger said.