How Rising Interest Rates May Affect Your Estate Planning Strategy

Interest rates are a key driver in today's economy and financial markets. They also can have a direct impact on certain estate planning strategies. Wealth holders who plan to transfer assets to heirs or charities via trusts may need to consider how the current upward trend in interest rates could help or hinder their plans.

Trusts and Interest Rates -- What Is the Connection?

When an individual creates certain types of trusts, he or she makes a gift to the trust's remainder beneficiaries that is subject to the federal gift tax. To establish the present value of the gift and any gift and/or estate tax implications, the IRS uses many criteria, including the applicable federal interest rate (AFR), defined under section 1274(d) of the Internal Revenue Code, which is tied to prevailing interest rates and published monthly by the IRS.

In a rising interest rate environment, the AFR has a favorable effect on some trust structures. Consider, for instance, the qualified personal residence trust, or QPRT. A QPRT allows a property owner to transfer a home or vacation property into a trust and retain the right to live in the home for a pre-stated period of time. At the end of that period, ownership of the property passes to the trust's remainder beneficiaries.

In general, the higher the interest rate at the time of the transfer and the longer the term of the trust, the lower the value of the remainder interest and subsequent gift tax obligation. One caveat: If the grantor dies before the term of the trust has expired, the property will transfer back into the grantor's estate at its value on the date of death.

In a similar way, rising interest rates may enhance the appeal of charitable remainder trusts, or CRTs. An individual may place assets in a CRT and name one or more charities as beneficiaries, while continuing to draw an annuity stream from the trust during his or her lifetime. The grantor is entitled to a tax deduction for the present value of the remainder interest, which again is calculated using the current applicable federal rate and the grantor's life expectancy, among other criteria. In this example, the higher the interest rate at the time of valuation, the greater the tax deduction for the grantor and/or the higher the annuity payment.

Not all trusts fare well in a rising interest rate environment, however. Charitable lead trusts (CLTs) -- which operate in an opposite manner to CRTs -- and GRATs, grantor retained annuity trusts, lose their tax planning benefits as interest rates climb. CLTs and GRATs are tied to the Section 7520 rate, which is 120% of the mid-term applicable federal rate. In order to be successful, these trust structures must outperform the Section 7520 rate -- that is, whatever a CLT or GRAT earns above the stated interest rate shifts to beneficiaries gift tax free. Should the trust assets underperform the interest rate, beneficiaries receive less than anticipated when the trust was created, in which case an outright transfer of property would have yielded better results. Given these specifications it is easy to see why a lower or declining interest rate environment favors these wealth transfer mechanisms.

Of course, interest rates are just one of the points that need to be considered when determining the most appropriate trusts for your needs. Contact a legal, tax, or accounting professional to find out more about trusts and how they may suit your specific circumstances.

For additional information, call Washington Trust Wealth Management at 800-582-1076.